You probably know that taking money out of your retirement account before age 59.5 will probably trigger early distribution penalties. But did you know that there are others? Here are the top three retirement account penalties that many people don't know about.
1. Improper rollovers
You've left your job and now you're looking to roll your 401(k) into an IRA. You could do a direct transfer, in which the money goes straight into your new 401(k) or an IRA, or you could do a manual rollover. Most people will go with the former, but in some cases it's necessary or preferable to use the latter.
A manual rollover involves taking the cash from your 401(k) and manually depositing it into the new 401(k) or IRA. Some people do it because it provides a short-term loan -- but you can get slammed with penalties if you don't pay it back.
This is all the more pressing an issue because your former employer will automatically withhold 20% of the account value for taxes to cover the contingency that you might not get it rolled over. You then have 60 days to get both the money you received plus what was withheld into your new 401(k) or IRA. In other words, you have to pony up the withheld amount out of your own funds to avoid being hit with additional taxes and early distribution penalties (although you'll get credit for the withholding on your tax return).
So, before you do a rollover rather than a transfer, be sure you have a funding source for that extra 20% -- and can get the job done within the 60-day period.
2. Over-contributing to retirement accounts
It sounds impossible to many, but contributing too much can easily happen if you're a big saver (or have a high enough income). It's also an easy mistake to make if you're in the "phase-out" income bracket for Roth IRAs. In most cases, you might be automatically sending cash to your 401(k) or IRA, and if you don't stop the outflows in time you can find yourself over the annual limits.
If you send too much to your IRA, you'll need to withdraw the amount and any related income to avoid getting hit with a 6% annual penalty. Generally speaking, your deadline for fixing an over-contribution in the previous year is the same as your tax-filing deadline, so if you ask for an extension, you can get six months beyond April 15 to make the withdrawal.
There's a special formula that you can use to determine the amount you need to withdraw, which is why you might want to ask your accountant for help -- or use the formula the IRS provides to determine the excess amount.
It's a little easier to correct an over-contribution to your 401(k). In this case, get in touch with your plan administrator to correct your W-2s and rectify the mistake. Just make sure to do this as early as possible before April 15, or else you could end up having to explain why there are disparities in your reported income versus what shows up on your W-2.
3. Miscalculating your required minimum distributions
Required Minimum Distributions, or RMDs, are the aspect of retirement accounts that you want to avoid messing up at all costs.
Unless you're still working, once you're over 70.5 years old, you have to start taking RMDs from your 401(k) and traditional IRA accounts. This requires a calculation to determine the minimum, which changes every year. If you take too little (or nothing at all), you'll be hit with a penalty equal to 50% of the shortfall.
You can ask for a waiver if you made a mistake, but this is probably not something you want to deal with -- so make sure to work through your RMD carefully so that you don't end up with the IRS knocking later on.
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