Contributing to an IRA is always a smart move. By putting money into an IRA, you basically get to tell the tax man to take a hike -- and can often put extra cash in your pocket as part of the bargain.
But as you would expect of such a nice deal, some people abuse the system. After years of being fairly lax about enforcing rules governing IRAs, the Internal Revenue Service plans to start cracking down on those who don't follow the tax laws to the letter -- and you'll want to be careful to make sure you don't inadvertently find yourself caught in the sting.
The crazy-complicated world of IRAs
A report in The Wall Street Journal over the weekend detailed the problem the IRS faces and its plans to deal with it. The move represents a change in direction for the IRS, which until now has been going after high-dollar-value areas like millionaire audits and ferreting out foreign bank and investment accounts.
But there's huge money at stake. The Journal cited figures from the Investment Company Institute claiming that 46 million households hold a total of $4.9 trillion within IRAs. And with tax laws as complicated as they are, you can get tripped up in a lot of ways:
- Contributing more than the $5,000 annual limit -- or $6,000 for those age 50 or older -- can cost you 6% of the extra amount you put in. Moreover, that penalty applies each and every year until you catch the mistake and pull the money back out.
- With Roth IRAs, income limits can put further restrictions on your ability to make contributions. Because many people make contributions before they have any idea how much they're going to earn in a given year, it's easy to forget to go back and make sure you didn't make a mistake.
- Retirees have to remember rules for taking money out of IRAs as well. For traditional IRAs, you have to take minimum distributions from your IRA starting at age 70 1/2. For inherited IRAs, on the other hand, those required distributions typically start right away. Either way, the IRS can hit you with a draconian 50% penalty on what you should have taken out if you forget.
- If you move an IRA from one company to another -- or pull out of a 401(k) to roll over to an IRA -- you only have 60 days to get everything moved. If you hold onto the funds longer than that, you could turn the entire amount into a taxable distribution, creating a potentially huge tax bill.
With so many ways to slip up, how can you protect yourself? There's no perfect solution, but here are some ideas to consider.
1. Keep things simple.
One of the easiest ways to get yourself in trouble is to have a bunch of IRA accounts at different institutions. Having all your retirement money in one place makes it easier to rely on figures that your financial company provides, even though you'll still have to do some due diligence on your own.
2. Have income ready.
When you need to take minimum distributions, many retirees are reluctant to sell off stocks or funds in order to raise cash. That's where income-producing assets become essential.
During the first few years of retirement, you need somewhere between 4% and 5% in order to meet the required income distribution. That makes high-quality stocks Eli Lilly (NYS: LLY) and AT&T (NYS: T) viable options from a dividend perspective, as their current yields are about in that range. Both have solid, stable business models that make them reasonably good choices even for risk-averse retirees.
As you get older, though, it becomes more difficult to produce enough cash flow to cover distributions. You can find some interesting investments that can get you there -- energy companies Seadrill (NYS: SDRL) and Linn Energy (NAS: LINE) can tap you into 7% to 8% yields, while mortgage REIT American Capital Agency (NAS: AGNC) gets you well into double-digit percentages. But they have a lot more risk than blue-chip stocks, as Seadrill and Linn are exposed to changes in energy demand, and American Capital Agency has interest-rate risk. The more prudent course is to set up a plan to make regular sales in order to produce liquidity to make IRA distributions.
3. Double-check at year-end.
By late December, you should have a firm grip on your income for the year. So be sure to go back and make sure your initial estimates of whether you'd be eligible to contribute to an IRA were accurate -- and if not, contact your financial company to figure out how to undo the damage before the IRS catches you.
The IRS has tried to build a kinder, gentler reputation lately, but economic and budget realities put a limit on its leniency. Follow the rules of IRAs, and you'll preserve your ability to use one of your most valuable tools for saving for retirement.
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The article Keep the IRS Away From Your IRA originally appeared on Fool.com.Fool contributor Dan Caplinger holds the IRS largely at bay. He doesn't own shares of the companies mentioned in this article. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Seadrill. Motley Fool newsletter services have recommended buying shares of Seadrill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy won't sic the tax man on you.
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