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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 (NYSE: LLY  ) and AT&T (NYSE: 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 (NYSE: SDRL  ) and Linn Energy (Nasdaq: LINE  ) can tap you into 7% to 8% yields, while mortgage REIT American Capital Agency (Nasdaq: 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.

Be careful out there
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.

If you're looking for better ways to invest your IRA, we've got you covered. The Motley Fool's special report on investing for retirement gives you three stock ideas that could give you everything you want in a long-term investment. Just click here and start reading your free copy right now.

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.

Read/Post Comments (6) | Recommend This Article (28)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 27, 2012, at 4:02 PM, prginww wrote:

    Several Fools have noted that MLPs can raise tax issues in IRAs related to unrelated business taxable income. The purpose in this article was to show that high enough yields are available from certain investments to produce the income necessary for minimum distributions, but you should be sure that UBTI doesn't cause problems in your individual tax situation.


    dan (TMF Galagan)

  • Report this Comment On June 27, 2012, at 5:00 PM, prginww wrote:


    I am 80 now and have plenty experience meeting my RMD for each year, choosing assets from one or both of my Schwab and Etrade Ira's. One BIG problem for me has been the IRS rule to value each IRA as of 31 Dec!!!

    Would you believe that the market tops-out every 31 Dec for the last few years??? By the time I take my RMD, I have to use assets that have de-valued since 31 Dec.

    I would like to see some rule that sets an AVERAGE value for setting the RMD....whaddaya say???

  • Report this Comment On June 29, 2012, at 12:07 PM, prginww wrote:

    Why all this focus on cash in your IRA? You don't need to withdraw "cash" at RMD time. I keep reading about this "problem" and it infuriates me that so-called informed financial writers are so ill-informed about RMDs. So long as you withdraw at least the RMD's worth of assets from the IRA, it doesn't matter whether it's cash or other assets.

    My husband has often pulled out stock shares instead of cash. It's a perfectly kosher thing to do. At RMD time, he "withdraws" a number of shares of stock that just barely exceed the RMD, by instructing his broker to move them from the IRA to his "regular" account. He meets the RMD requirement without having to sell his shares, and the "basis" cost in his regular account becomes the market value of the shares on the day of the transfer. That way, he avoids having to sell and re-purchase shares of a stock he wants to hold on to, while still meeting his RMD.

    This is a perfectly legitimate way to take your RMD. Please stop making people think they have to liquidate their assets in order to take their RMD, when they don't. Thank you.

  • Report this Comment On June 29, 2012, at 1:52 PM, prginww wrote:



    The best ideas are always the simplest!

    I was just beginning to wonder how I would handle this.



  • Report this Comment On June 29, 2012, at 2:00 PM, prginww wrote:

    i don't know that any of this article is really all that new. but i truly appreciate Winehouse's comments -- it's time for us to remember that brokers love the idea of 'sell' as a mandatory rather than an optional strategy.

    further, i believe it is possible (esp. early in retirement) to re-invest unneeded RMD into one's ROTH provided the new assets remain a minimum of five years before being withdrawn again. someone correct me if i'm wrong . . .

  • Report this Comment On July 05, 2012, at 9:02 AM, prginww wrote:

    What is "RMD?" And you can have multiple IRAs with different brokerages?! Can the total of those go over the $5k max?

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