Avoiding expensive consequences of improperly handling your IRA assets means knowing which transactions will result in penalties. Some of these transactions are well known while others are not. To help you prevent being caught off guard, we explain some of the common transactions and mistakes that could result in IRS penalties on your IRA assets or IRA-related transactions.

Early-Distribution Penalty If you are under age 59.5 when a distribution occurs from your IRA, you may have to pay an early-distribution penalty (also referred to as a 10% additional tax) on the gross distribution amount. The IRS makes exceptions to the 10% early-distribution penalty if you meet certain requirements. If you qualify for one of these or any other exception, you must either have the IRA custodian/trustee report the distribution as one that meets an exception or file the necessary IRS forms to claim the exception (see below for details). Improper reporting could result in having to pay penalties that could have been avoided. (For more insight, see Can I take money out of my IRA if I'm still working?)

Tax on Excess Contributions Each year there is a maximum limit on the amount you may contribute to an IRA. For instance, for 2010, the limit is $5,000. Contributions in excess of the limit are referred to as "excess contributions", and they must be removed (plus any earnings or minus any losses) by your tax-filing deadline (including extensions) for the year. For instance, if you made an IRA excess contribution in May of this year, the excess amount must be removed from your IRA by April 15 of next year (plus tax-filing extensions). If the excess amount is not removed by this deadline, a 6% tax is assessed on the excess amount for each year that the excess remains in the IRA. This extra tax could result in a substantial amount, and failure to remove the excess amount in a timely manner could result in double taxation of the assets.

ExampleJane has two IRAs at different financial institutions, and in 2010 (for which the limit was $5,000) she contributed $7,000 to each IRA, resulting in an excess contribution of $9,000 ($14,000 - $5,000). Jane was under age 50 and therefore was not allowed to make catch-up contributions, so the maximum amount she was allowed to contribute for the year was $5,000. Jane did not remove the excess amount by her tax-filing deadline for 2010, so she was required to pay the 6% tax on the excess amount for each year that it remained in her IRA. Also, for the year that she finally distributed the excess amount from her IRA, she had to add the amount to her taxable income. Since she was under age 59.5, she owed also the 10% early-distribution penalty on the amount, unless she qualified for an exception (to the penalty).Note: If the excess contribution had been $5,000 (the contribution limit for the year) or less, Jane wouldn\'t have been required to add the amount to her taxable income, and the 10% early-distribution penalty wouldn\'t have applied. She would\'ve owed only the 6% tax for each year the excess remained in the IRA.

Excess-Accumulation Tax If you are a Traditional IRA owner, (or SEP or SIMPLE IRA owner), you must begin taking required minimum distributions (RMD) from your IRAs the year you reach age 70.5, and you must distribute a minimum amount from the IRA each subsequent year. Failure to distribute the RMD amount will result in a 50% penalty on the amount not distributed. For example, if your RMD for this last year was $5,000 and you distributed only $4,000 from your IRA, you will owe the IRS $500 (50% of $1,000).

Filing IRS Form 5329 There may be instances in which your IRA custodian/trustee may report your IRA distribution that is exempt from the 10% early-distribution penalty as a distribution that is not exempt. For instance, if your distribution is used toward the purchase of your first home, you are not required to report the distribution as one that is exempt from the penalty, even though it is exempt. If your IRA custodian did not indicate that the distribution is exempt from the early-distribution penalty, you may file IRS Form 5329 to claim the exception. Failure to file this form could result in you paying the 10% early-distribution penalty even though an exception applies.

IRS Form 5329 is also used to file the error that occurs when an IRA custodian reports a non-exempt distribution as one that is exempt from the early-distribution penalty. The IRA holder would file the form to notify the IRS that the exception does not apply and pay the penalty.

Filing Form 8606 and Consequences of Overstating Amounts on Form 8606 You must file IRS Form 8606 for each year that you make a nondeductible contribution to your Traditional IRA and for each subsequent year that you make a distribution from any one of your Traditional IRAs. Form 8606 serves to notify the IRS of the nondeductible contribution and helps you determine the portion of a distribution that is nontaxable. If you fail to file form 8606, you could end up paying taxes on an otherwise nontaxable amount. Make sure you keep track of the nontaxable assets and file the form to determine the nontaxable portion. In addition, there is a $50 IRS penalty for failure to file Form 8606.

Finally, you must take care not to overstate amounts on Form 8606, as there could be a $100 penalty for each overstatement. The IRS may waive the penalty in circumstances wherein the overstatement was due to a reasonable cause.ConclusionYou don't want to suffer avoidable penalties and taxation on any IRA transactions, so be sure to consult your tax professional regarding transactions that could result in penalties. The more you know about the restrictions on contributions and distributions, the better you will be at bypassing unnecessary charges.

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