7. WHAT ACTS RESULT IN PENALTIES? The tax advantages of using IRAs for retirement savings can be offset by additional taxes and penalties if you do not follow the rules. For example, there are additions to the regular tax for using your IRA funds in prohibited transactions. There are also additional taxes for: o Making excess contributions, o Making early withdrawals (taking premature distributions), o Allowing excess amounts to accumulate (failing to make required withdrawals), or o Receiving excess distributions. There are penalties for overstating the amount of nondeductible contributions and for failure to file Form 8606, Nondeductible IRA Contributions, IRA Basis, and Nontaxable IRA Distributions, if required. This chapter discusses those acts that you should avoid and the additional taxes and other costs, including loss of IRA status, that apply if you don't. Prohibited Transactions Generally, a prohibited transaction is any improper use of your IRA account or annuity by you or any disqualified person. Some examples of disqualified persons for this purpose are: Your fiduciary, or Members of your family (spouse, ancestor, lineal descendant and any spouse of a lineal descendant). Some examples of prohibited transactions with an IRA are: 1) Borrowing money from it, 2) Selling property to it, 3) Receiving unreasonable compensation for managing it, and 4) Using it as security for a loan. Effect on an IRA account. Generally, if you or your beneficiary engage in a prohibited transaction in connection with your IRA account at any time during the year, it will not be treated as an IRA as of the first day of the year. Effect on you (or your beneficiary). If you (or your beneficiary) engage in a prohibited transaction in connection with your IRA account at any time during the year, you (or your beneficiary) must include the fair market value of all (or part, in certain cases) of the IRA assets in your gross income for that year. The fair market value is the price at which the IRA assets would change hands between a willing buyer and a willing seller, when neither has any need to buy or sell, and both have reasonable knowledge of the relevant facts. You must use the fair market value of the assets as of the first day of the year you engaged in the prohibited transaction. You may also have to pay the 10% tax on premature distributions and the 15% tax on excess distributions, discussed later. Excise taxes. You or any disqualified persons involved in prohibited transactions may be liable for certain excise taxes in addition to the taxes on premature distributions and excess distributions. In general, there is a 5% tax on the amount of the prohibited transaction, and a 100% additional tax if the transaction is not corrected. If the IRA ceases to be an IRA because of a prohibited transaction by you (or your beneficiary), you (or your beneficiary) are not liable for these excise taxes. However, you (or your beneficiary) may have to pay other taxes as discussed above under Effect on you (or your beneficiary). Borrowing on an annuity contract. If you borrow money against your IRA annuity contract, you must include in your gross income the fair market value of the annuity contract as of the first day of your tax year. You may also have to pay the 10% additional tax on premature distributions, the 15% tax on excess distributions and the excise taxes discussed above. Pledging an account as security. If you use a part of your IRA account as security for a loan, that part is treated as a distribution and is included in your gross income. You may have to pay the 10% additional tax on premature distributions, the 15% tax on excess distributions and the excise taxes discussed above. Trust account set up by an employer or an employee association. Your account or annuity does not lose its IRA treatment if your employer or employee association, with whom you have your IRA, engages in a prohibited transaction. If you participate in the prohibited transaction with your employer or association, your account is no longer treated as an IRA. Other Acts to Avoid The following acts are also prohibited: Investment in collectibles. If your IRA invests in collectibles, the amount invested after 1981 is considered distributed to you in the year invested. You may also have to pay the 10% tax on premature distributions, the 15% tax on excess distributions, and the excise taxes discussed earlier. Collectibles include art works, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages, and certain other tangible personal property. Exception. Your IRA can invest in one, one-half, one-quarter, or one-tenth ounce U.S. gold coins, or one-ounce silver coins minted by the Treasury Department. Acceptance of certain cash, property or services. If you accept certain cash, property, or services offered by any financial institution because the institution maintains an IRA for you, it may be considered a prohibited transaction. However, until the Department of Labor makes a final decision regarding a request for exemption from the prohibited transaction rules for the above items, the IRS will not raise issues concerning such transactions. Excess Contributions Generally, an excess contribution is the amount contributed to your IRAs that is more than the smaller of the following amounts: 1) Your taxable compensation for the year, or 2) $2,000. The taxable compensation limit applies whether your contributions are deductible or nondeductible. Contributions for the year you reach age 70 1/2 and any later year are also excess contributions. An excess contribution could be the result of your contribution, your spouse's contribution, your employer's contribution, or an improper rollover contribution. If your employer makes contributions on your behalf to a SEP-IRA, see Chapter 8, Simplified Employee Pension (SEP). Tax on excess contributions. If the excess contribution for a year is not withdrawn by the date your return for the year is due (including extensions) as explained later, you are subject to a 6% tax. You must pay the 6% tax each year on excess amounts that remain in your IRA at the end of your tax year. The excess is taxed for the year of the excess contribution and for each year after that, until you correct it. The tax cannot be more than 6% of the value of your IRA as of the end of your tax year. The excise tax is figured on Form 5329. For information on filing Form 5329, see Reporting Additional Taxes, later. Example. For 1992, Paul Jones is single, his compensation is $31,000, and he contributed $2,500 to his IRA. Paul has made an excess contribution to his IRA of $500 ($2,500 minus the $2,000 limit). The contribution earned $5 interest in 1992 and $6 interest in 1993 before the due date of the return, including extensions. He does not withdraw the $500 or the interest it earned by the due date of his return, including extensions. Paul figures his excess contribution tax by multiplying the excess contribution ($500) shown on line 6, Form 5329, by .06, giving him an additional tax liability of $30. He enters the tax on line 7, Form 5329, and on line 51, Form 1040. Excess contributions you withdraw by the date your return is due. You will not have to pay the 6% tax if you withdraw an excess contribution made during a tax year and interest or other income earned on it by the date your tax return for that year is due, including extensions. Do not include in your gross income an excess contribution that you withdraw from your IRA before your tax return is due if: 1) No deduction was allowed for the excess contribution, and 2) The interest or other income earned on the excess was also withdrawn. However, you must include in your gross income the interest or other income that was earned on the excess contribution. Report it on your return for the year in which the excess contribution was made. Your withdrawal of interest or other income may be subject to an additional 10% tax on early withdrawals, discussed later. Form 1099-R. You will receive Form 1099-R indicating the amount of the withdrawal. If the excess contribution was made in a previous tax year, these forms will indicate the year in which the earnings are taxable. Excess contributions you withdraw after your return is due. If the total contributions (other than rollover contributions) for the year to your IRA are $2,250 or less, and there are no employer contributions for the year, you can withdraw any excess contribution after the due date for filing your tax return for that year, including extensions, and not include the amount withdrawn in your gross income. This applies only to the part of the excess for which you did not take a deduction. The 6% tax applies to the excess contribution amount that remains in your IRA at the end of a year (this includes the year of the contribution and any later year). Excess contribution deducted in an earlier year. If you deducted an excess contribution in an earlier year for which the total contributions were $2,250 or less, and for which there were no employer contributions, you can still remove the excess from your IRA and not include it in your gross income. To do this, file Form 1040X, Amended U.S. Individual Income Tax Return, for that year and do not deduct the excess contribution on the amended return. Generally, you can file an amended return within 3 years after you filed your return, or 2 years from the time the tax was paid, whichever is later. Excess due to incorrect rollover information. If an excess contribution in your IRA is the result of a rollover, and the excess occurred because you had incorrect information required to be supplied by the plan, you can withdraw the excess contribution. The $2,250 limit, mentioned above, is increased by the amount of the excess that is due to the incorrect information. You will have to amend your return for the year in which the excess occurred to correct the reporting of the rollover amounts in that year. Do not include in your gross income, in the year you withdraw it, the excess contribution that was the result of the incorrect information. Taking a deduction in a later year for an excess contribution. You cannot reduce an excess by applying it against an earlier year in which less than the maximum amount allowable was contributed. But you can apply it to a later year if the contributions for that later year are less than the maximum allowed for that year. You can deduct from your gross income, in the first available tax year, the amount of the excess contributions in your IRA, from preceding years, up to the difference between the maximum amount that is deductible in the year and the amount actually contributed during the year. This method lets you avoid making a withdrawal. It does not, however, let you avoid the 6% tax on any excess contributions remaining at the end of a tax year. Example. Terry was entitled to contribute to her IRA and deduct $1,000 in 1991 and $1,500 in 1992, the amounts of her taxable compensation for these years. In 1991, she actually contributed $1,400 but could deduct only $1,000. In 1991, $400 is an excess contribution, subject to the 6% tax. However, she would not have to pay the 6% tax if she withdrew the excess (including any earnings) before the due date of her 1991 return. Since Terry did not withdraw the excess, she owes excise tax of $24 for 1991. To avoid the excise tax for 1992, she can correct the $400 excess amount from 1991 in 1992 if her actual contributions are only $1,100 in 1992 (the allowable deductible contribution of $1,500 minus the $400 excess from 1991 she wants to treat as a deductible contribution in 1992). Terry can deduct $1,500 in 1992 (the $1,100 actually contributed plus the $400 excess contribution from 1991). Closed tax year. A special rule applies if you incorrectly deducted part of the excess contribution in a closed tax year (one for which the period to assess a tax deficiency has expired). The amount allowable as an IRA deduction for a later correction year (the year you contribute less than the allowable amount) must be reduced by the amount of the excess contribution deducted in the closed year. Premature Distributions (Early Withdrawals) You must include in your gross income premature distributions (sometimes called early withdrawals or early distributions) from your IRA. They are also subject to an additional tax, as discussed below. Premature distributions are amounts you withdraw from your IRA account or annuity before you are age 59 1/2, or amounts you receive when you cash in retirement bonds before you are age 59 1/2. Exceptions. In certain circumstances, the additional tax does not apply to distributions from your IRA, even though they are made before you are age 59 1/2. There are exceptions for: o Disability, o Death, o Rollovers, and o Annuity distributions. The exceptions are discussed in detail near the beginning of Chapter 6 under Exceptions. Receivership Distributions. Premature distributions (with or without your consent) from savings institutions placed in receivership are subject to this tax unless one of the exceptions discussed above applies. This is true even if the distribution is from a receiver that is a state agency. Additional tax. The additional tax on premature distributions is equal to 10% of the amount of the premature distribution that you must include in your gross income. This tax is in addition to any regular income tax that is due. Use Form 5329 to figure the tax. See the discussion of Form 5329, later, under Reporting Additional Taxes, for information on filing the form. Example. Tom, who is 35 years old, withdraws $3,000 from his IRA account. The $3,000 is a premature distribution. Tom must include the $3,000 in his gross income for that year and pay income tax on it. Tom must also pay an additional tax of $300 (10% x $3,000). Nondeductible Contributions. The tax on premature distributions does not apply to the part of a distribution that represents a return of your nondeductible contributions (basis). Excess Accumulations (Insufficient Distributions) Amounts contributed to your IRA cannot be kept in it indefinitely. In general, you must begin receiving distributions by April 1 of the year following the year in which you reach age 70 1/2 . Tax on excess. If distributions are less than the required minimum distribution for the year, discussed in Chapter 6, you may have to pay a 50% excise tax for the year on the amount not distributed as required. Reporting the tax. Use Form 5329 to report the tax on excess accumulations. See the discussion of Form 5329, later, under Reporting Additional Taxes, for more information on filing the form. Request to excuse the tax. If the excess accumulation is due to reasonable error, and you have taken, or are taking, steps to remedy the insufficient distribution, you can request that the tax be excused. How to file the request. File Form 5329 with your Form 1040 and pay any tax you owe on excess accumulations. Attach an explanation for the excess accumulation and show when you removed the excess or what you have done that will result in its withdrawal. If the IRS approves your request, it will refund the excess accumulations tax you paid. Exemption from tax. If you are unable to make required distributions because you have an IRA invested in a contract issued by an insurance company that is in state insurer delinquency proceedings, the 50% excise tax does not apply if the conditions and requirements of Revenue Procedure 92-10 are satisfied. Those conditions and requirements are summarized below. You can read the full text of the revenue procedure at most IRS offices and at many public libraries. Conditions. To qualify for exemption from the tax, the assets in your IRA must include an affected investment . Also, the amount of your required distribution must be determined as discussed in Chapter 6. Affected investment means an annuity contract or a guaranteed investment contract (with an insurance company) for which payments under the terms of the contract have been reduced or suspended because of state insurer delinquency proceedings against the contracting insurance company. Requirements. If your IRA (or IRAs) includes other assets in addition to your affected investment, all IRA assets, including the available portion of your affected investment, must be used to satisfy, to the extent possible, your IRA distribution requirement. If the affected investment is the only asset in your IRA, the required distribution, to the extent possible, must come from the available portion, if any, of your affected investment. Available portion. The available portion of your affected investment is the amount of payments remaining after they have been reduced or suspended because of state insurer delinquency proceedings. Make up of shortfall in distribution. If the payments to you under the contract increase because all or part of the reduction or suspension is canceled, you must make up the amount of any shortfall in a prior distribution because of the proceedings. You make up (reduce or eliminate) the shortfall with the increased payments you receive. You must make up the shortfall no later than December 31 of the calendar year following the year that you receive increased payments. Excess Distributions If you received retirement distributions during the year of more than $150,000, you may have to pay a 15% tax on the distributions exceeding that amount. The term retirement distributions means your distributions from any qualified employer plan (including a tax-sheltered annuity plan), or IRA. Use Form 5329 to figure the tax. See the discussion of Form 5329, later, under Reporting Additional Taxes. This excise tax is reduced by any tax on premature distributions that applies to the excess distribution. See Premature Distributions, discussed earlier. Excluded distributions. The excess distribution tax does not apply to the following distributions: 1) Distributions after the death of the IRA owner (or employee in the case of employer plans), 2) Distributions that are rolled over, 3) Distributions that represent nondeductible contributions, 4) Corrective distributions of excess deferrals under a salary reduction arrangement (or a similar qualified plan) discussed in Chapter 8, 5) Corrective distributions of excess aggregate contributions, and 6) Corrective distributions of excess annual additions. Combining distributions. If distributions with regard to a person are made to that person and others, the distributions must be combined to figure the amount of excess distributions for the year. Special limitation on tax. On a return filed for a tax year ended before January 1, 1989, you could have chosen not to pay the 15% tax on the part of any distribution that is related to your accrued benefits on August 1, 1986. This rule applies only if the accrued benefit as of August 1, 1986, exceeded $562,500. However, if you made this choice to exclude from the tax on excess distributions a distribution amount allocable to your August 1, 1986, benefit accruals, your other retirement distributions are subject to the tax to the extent they are more than $140,276 for 1992 (instead of $150,000). Furthermore, this $140,276 amount is reduced (but not below zero) by any distributions received during the year that are allocable to the August 1, 1986, benefit accruals. If you did not elect to apply this rule, then the 15% tax will apply to the part of the distribution that exceeds $150,000. Increase in estate tax. For decedents dying after December 31, 1986, the estate tax will be increased by 15% of the excess retirement accumulation. A person's excess retirement accumulation, if any, is the value of the decedent's interests in all qualified employee plans, tax-sheltered annuities, qualified annuity plans, individual retirement accounts, and any other plans that the Internal Revenue Service may include, over the "present value" of a single life annuity with payments equal to the annual ceiling ($150,000), and payable for a period equal to the decedent's life expectancy immediately before death. The tax may not be offset by any credits against the estate tax, such as the unified credit. Reporting Additional Taxes Use Form 5329 to report the tax on excess contributions, premature distributions, excess distributions, and excess accumulations. You also must file Form 5329 if you: o Meet an exception to the 10% additional tax on early (premature) distributions, but only if the exception is not shown on the Form 1099-R that you received for the distribution, or o Receive excess distributions from a qualified retirement plan, whether or not you owe tax on them. If you file Form 1040, complete Form 5329 and attach it to your Form 1040. Enter the total amount of IRA tax due on line 51, Form 1040. If you do not have to file a Form 1040 but do have to pay one of the IRA taxes mentioned earlier, file the completed Form 5329 with IRS at the time and place you would have filed Form 1040. Include a check or money order payable to Internal Revenue Service for the tax you owe, as shown on Form 5329. Write your social security number, tax form number, and tax year on your check or money order.