The 5 Most Dangerous IRA Mistakes You Can Make

retirement eggBy Terry Savage, Author, The Savage Truth on Money

We're "out of season" on IRAs. Unlike the tax-time crunch, few people are spending time thinking about their Individual Retirement Accounts. And that makes it the perfect time to remind you how to avoid some expensive IRA mistakes.

IRA expert Ed Slott (www.IRAHelp.com) says the most costly mistakes you can make with your IRA do not come from investment losses. Instead, they are the taxes and penalties that arise when you make mistakes as a result of your own ignorance -- or the wrong advice you might receive at your financial institution. It's up to you to know the rules.

Most people are aware that if you withdraw money from a traditional, tax-deductible IRA before age 59½, you are subject not only to ordinary income taxes, but a 10% federal tax penalty. That's designed to keep your savings growing over the years.

But these days, many desperate people are taking money out of retirement accounts early. Many are unaware that this is a very costly move. Others decide just to move their accounts to a new financial firm. But, depending on how you handle the move, you could also be vulnerable to taxes and penalties.

Slott gives examples of the five most common, and costly, IRA mistakes:

1. The Rollover Rule


A rollover occurs when you move an account from one custodian to another, but instead of having the account transferred directly from custodian to custodian, you take the money in the form of a check, and then open a new account. That's considered a rollover.

You must move the money to a new custodian within 60 days -- or it will be treated as a withdrawal, and you'll pay applicable taxes and a penalty, if you're under age 59½. And you are allowed only one rollover per year. Do a second one, and you'll pay those taxes and penalties.

Solution: Have the money transferred directly from custodian to custodian, without taking a check. You can do unlimited account transfers in a year, but only one rollover.

2. Withdraw from IRA for Education

If you will need to withdraw for education, move the 401(k) funds to your IRA (if your plan allows, typically if you've lost your job) and withdraw from the IRA to pay education bills penalty-free. The education exception applies only to distributions from IRAs, not from company plans.

If you really need the money, and if your company plan allows, you can "borrow" from your 40l(k). But if you lose your job and haven't returned the money, it will count as a withdrawal.

3. Set Aside Money for Taxes on Withdrawals

Whether you're taking cash out early, or taking the annual mandatory withdrawals required in the year you reach age 70½, set aside the cash to pay the taxes when your next tax return is due. Otherwise you'll get caught in a vicious cycle, needing to withdraw more to pay taxes next year.

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4. Avoid Mandatory Withholding

When you do a rollover, instead of a direct transfer from a company plan, the custodian of your original account is required to withhold 20% for taxes.

You can file to get the withholding back next year if you've truly rolled the account into another IRA. But that's money that won't be working for you. So, again, do a direct custodian-to-custodian transfer, which requires no withholding.

5. The age 59½ Rule is Specific

Many people think you can withdraw from an IRA penalty-free in the year you reach age 59½. Wrong. You must actually be 59½ to avoid penalties! So count 183 days from your last birthday before taking a withdrawal!

And a final bit of IRA advice from Ed Slott, one that could save you a lot of money in taxes in the future: Consider a Roth IRA conversion now!

Slott notes that it's been a universal "rule" not to pay taxes before you must. However, we are facing potentially huge tax increases in the years ahead. If you convert from a traditional IRA to a Roth IRA, you will owe taxes next April -- at this year's marginal tax rates, which are near the lowest in recent history.

All future gains will come out tax-free. And there will be no required mandatory withdrawals, so if you don't actually need the money during your retirement years, it can go to your heirs, who can keep it growing tax-free.

Of course, you'll need money outside your IRA to pay the taxes, or you lose some of the benefits of the conversion. But you're taking money that is earning only 0.25% to pay taxes that would surely be higher in the future. Not a bad trade. And that's the Savage Truth.

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18 Comments

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Farthead

I know this article is old, but the author is incorrect about Rollovers. You are limited to one Rollover per year PER ACCOUNT not per person. If you have 10 IRA accounts you can Rollover once per year out of each one. In fact, you can borrow for 60 days from each account per year. There are no limits as to how many IRA accounts you can open.

December 19 2013 at 1:52 PM Report abuse rate up rate down Reply
mjswalsh

Understand that any contributions to an IRA must come from WAGES, not dividends, not interest, not even pension money. I learned this the hard way & got hit with penalty.

May 30 2012 at 1:57 AM Report abuse rate up rate down Reply
stick4013

sjpxmas - STOP YELLING !!! My two cents worth is that when you have to hire a CPA to do your taxes, then taxes (which are mandatory) become like credit card companies and the BOA. Your 5% interst rate goes to 75% plus fees. No one bothers to explain why or offers assistance. I do not understand IRS-speak. I dont mind paying my fair share but DANG !!!! They are like Con-men. -Richard

May 30 2012 at 1:08 AM Report abuse rate up rate down Reply
brian1russ

The big one they forgot here is the mandatory withdrawls at age 70 1/2. If you miss one of hese, the penalty is 50% of the required withdrawl.

May 30 2012 at 12:14 AM Report abuse rate up rate down Reply
Buckingham's

You forgot one: telling the IRS agent)s) to sit on a short stick.

May 29 2012 at 3:05 PM Report abuse rate up rate down Reply
sjpxmas

THE MORE MONEY YOU PUT IN THE BANK, THE GREEDIER YOU WILL BECOME,,,, YOU WANT MORE AND MORE MONEY, IN YOUR BANK ACCOUNT, THAN YOU DIE.. AND SOMEONE ELSE WILL SPEND YOUR MONEY...

May 29 2012 at 12:51 PM Report abuse rate up rate down Reply
sjpxmas

KEEP IT IN THE BANK, AND SOMEONE ELSE WILL SPEND YOUR MONEY ,THAT YOU SAVED A LONG
TIME FOR,,,ITS EITHER YOU DIE WITH YOUR MONEY, OR YOU LIVE YOUR MONEY...

May 29 2012 at 12:46 PM Report abuse rate up rate down Reply
sjpxmas

KEEP IT IN THE BANK, AND SOMEONE ELSE WILL SPEND YOUR MONEY ,THAT YOU SAVED A LONG
TIME FOR...

May 29 2012 at 12:43 PM Report abuse rate up rate down Reply
sjpxmas

JUST HOW MUCH MONEY IS NECESSARY TO KEEP IN THE BANK...

May 29 2012 at 12:41 PM Report abuse rate up rate down Reply
sjpxmas

NO ONE HAS ENOUGH MONEY, THERE IS ALWAYS ROOM FOR MORE..

May 29 2012 at 12:40 PM Report abuse rate up rate down Reply