7 IRA Tax Facts

This article is intended solely for informational purposes and does not constitute tax, legal or financial advice. The content provided here is not a substitute for professional advice from a qualified tax advisor, attorney or financial planner. Readers are encouraged to consult with a licensed tax professional or legal advisor to obtain advice tailored to their specific circumstances and ensure compliance with applicable laws and regulations.

When tax season is approaching, it means gathering documents, calculating your numbers and knowing which rules you need to follow. One area where taxpayers routinely get confused or overwhelmed is around Individual Retirement Account (IRA) guidelines.

Traditional and Roth IRAs are powerful tools to help you save for retirement. But the federal government has placed strict limits on when and how you can use IRA funds.

In this article, we look at common facts you need to know about IRAs before filing your taxes.

1. IRA accounts have contribution limits
When planning your retirement savings, it's important to understand that Individual Retirement Accounts (IRAs), both Traditional and Roth, include annual contribution limits set by the IRS. These limits determine how much money you can deposit into your IRA each year. They are also subject to change, so staying informed is essential.

The contribution limit for both types of IRAs is the same each year. However, it’s important to note that eligibility to contribute to a Roth IRA has an income ceiling and is based on filing status. Taxpayers may contribute the full amount if they are under certain income thresholds – but once your income exceeds these thresholds, the contribution limit is reduced or eliminated altogether.

Understanding these limits and the rules surrounding them can help you make the most of your retirement savings strategy, ensuring you're not leaving tax advantages on the table or facing unexpected penalties for over-contributing.

2. You may be able to deduct IRA contributions from your taxes
For Traditional IRAs, contributions are often tax-deductible. Depending on your income, filing status, and whether you're covered by a retirement plan at work, you may be able to deduct your contribution amounts from income levels on your tax filing. Deductions may be full, partial or none.

Roth IRA contributions, on the other hand, are made with after-tax dollars. This means you won't get a tax deduction upfront, but your withdrawals during retirement can be tax-free.

3. You have to contribute by a certain date
An important part of managing your IRA is knowing the deadline for contributions.

For both Traditional and Roth IRAs, contributions for a tax year can be made up until the tax filing deadline of the following year, typically April 15. This extended period allows taxpayers to make contributions that can still be counted towards the previous tax year, offering a useful opportunity for last-minute tax planning.

For example, if you're making contributions in March 2024, you have the option to allocate these funds towards your 2023 IRA contribution limit, as long as you haven't already reached the contribution maximum for the year.

Lastly, it's important to specify the tax year you want your contribution going to when making the deposit, especially if you're contributing between January 1 and April 15. This helps ensure your contributions are correctly applied.

4. You may be able to fund an IRA for your spouse
For couples where one spouse doesn't work, the Spousal IRA provision allows the working spouse to contribute to a Traditional or Roth IRA on behalf of the non-working spouse. The non-working spouse must open their own IRA, which is still subject to the income limitations.

This strategy effectively doubles the household's retirement savings potential, even if only one spouse has earned income. And the Spousal IRA is available as long as the couple files their taxes jointly.

The contribution limits for the Spousal IRA are typically the same as for a regular IRA, enabling the non-working spouse to accumulate tax-advantaged savings for retirement. Importantly, though, the total of the spouses’ combined contributions can't be more than the taxable compensation reported on a joint return. By meeting guidelines and making contributions to a Spousal IRA, you can enhance your retirement nest egg while also providing additional flexibility in tax planning.

5. Rollovers do not count toward your contribution limits (but there are rules)
If you have multiple retirement accounts, you may want to consolidate them by rolling over funds from one account to another.

Rollover contributions do not count towards your annual IRA contribution limit. This means you can move money between retirement accounts without affecting your ability to make annual contributions up to the IRS limit.

However, there are specific rules governing rollovers, especially between Traditional and Roth IRAs, to help ensure these transactions are conducted without tax penalties. Work with a tax advisor to understand these rules and avoid unintended tax consequences.

6. At a certain age, you have to withdraw from your IRA
Once you reach a certain age, the IRS mandates that you start taking Required Minimum Distributions (RMDs) from your Traditional IRA.

RMDs are the minimum amounts that a retirement plan account owner must withdraw annually, starting with the year that he or she reaches 73 years of age. Under the SECURE Act 2.0, Section 107, the minimum distribution age was raised to 73 starting on January 1, 2023. And the age is set to further increase to 75 starting on January 1, 2033.

Calculating your RMD involves dividing the prior year-end balance of your IRA by a distribution period from the IRS's Uniform Lifetime Table. If you have multiple IRAs, you must calculate the RMD for each account but can choose to withdraw the total amount from one or more of the IRAs. The IRS provides helpful worksheets for calculating your RMDs.

RMDs are taxable as ordinary income in the year you take the distribution, potentially pushing you into a higher tax bracket. Therefore, strategic planning around the timing and amount of these withdrawals is essential to minimize the tax impact. This may include starting withdrawals earlier or considering Roth IRA conversions to manage future tax liabilities.

7. If you don’t comply with IRA laws, there may be tax penalties
Navigating the rules of IRAs is crucial. Be sure to consult with your tax advisor when addressing the issues below.

Following these rules can help maximize your retirement savings and avoid costly penalties. The IRS imposes specific penalties for excess contributions and early withdrawals, emphasizing the importance of adhering to contribution limits and withdrawal rules.

Excess contributions

If you contribute more to your IRA (Traditional or Roth) than the allowable limit, you could face a tax penalty on the excess amount for each year it remains in your account. Consult your tax advisor for more information on your personal circumstance.

To avoid this penalty, excess contributions must be withdrawn, along with any income earned on the excess amount, before the tax filing deadline, including extensions. This corrective action requires careful calculation to help ensure all earnings associated with the excess contributions are accurately removed from the account.

Early withdrawals

Withdrawing funds from your IRA before reaching 59½ years of age generally results in an early withdrawal penalty on the distributed amount, in addition to the regular income tax owed.

There are exceptions to this rule, such as withdrawals used for qualified higher education expenses, first-time home purchases (up to a $10,000 limit), certain medical expenses exceeding a percentage of your adjusted gross income, or if you become disabled. The IRS provides a full list of exceptions on page 24 of publication 590-B. However, navigating these exceptions requires a thorough understanding of IRS rules to ensure compliance and avoid unnecessary penalties.

Minimum withdrawals

Failing to take your Required Minimum Distributions (RMDs) from a retirement account like a Traditional IRA can result in one of the most severe penalties imposed by the IRS. If you do not withdraw the full amount of your RMD by the deadline, or if you fail to take an RMD at all, the amount not withdrawn may be subject to a 25% excise tax (see page 28 of publication 590-B).This penalty is in addition to the income tax you may owe on the distribution.

The IRS does offer a waiver for the penalty if you can demonstrate that the shortfall was due to a reasonable error and that you are taking steps to rectify the mistake. You would need to file Form 5329 and attach a letter of explanation to request relief from the penalty.

In summary

These penalties underscore the IRS's intent to encourage the use of IRAs for long-term retirement savings rather than short-term financial needs.

Proper planning and adherence to IRA contribution and withdrawal rules are essential to helping avoid these penalties, maximize your retirement savings benefits, and ensure your financial strategy aligns with your long-term goals.

Want to learn more about financial topics like IRAs and retirement contributions?
Head over to Comerica Insights. You’ll find a wealth of articles covering everything from retirement and estate planning to investment strategies and charitable giving. Gain tips and resources that can guide you on your financial journey.

This article is intended solely for informational purposes and does not constitute tax, legal or financial advice. The content provided here is not a substitute for professional advice from a qualified tax advisor, attorney or financial planner. Readers are encouraged to consult with a licensed tax professional or legal advisor to obtain advice tailored to their specific circumstances and ensure compliance with applicable laws and regulations.