What Acts Result in Penalties?

The tax advantages of using traditional 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 the following activities.

• Investing in collectibles.
• Making excess contributions.
• Taking early distributions.
• Allowing excess amounts to accumulate (failing to take required distributions).

There are penalties for overstating the amount of nondeductible contributions and for failure to file Form 8606, 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 do not avoid those acts.

Prohibited Transactions

Generally, a prohibited transaction is any improper use of your traditional IRA account or annuity by you, your beneficiary, or any disqualified person.

Disqualified persons include your fiduciary and members of your family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).

The following are examples of prohibited transactions with a traditional IRA.

• Borrowing money from it.
• Selling property to it.
• Receiving unreasonable compensation for managing it.
• Using it as security for a loan.
• Buying property for personal use (present or future) with IRA funds.

Fiduciary. For these purposes, a fiduciary includes anyone who does any of the following.

• Exercises any discretionary authority or discretionary control in managing your IRA or exercises any authority or control in managing or disposing of its assets.
• Charges to provide investment advice with respect to your IRA, or has any authority or responsibility to do so.
• Has any discretionary authority or discretionary responsibility in administering your IRA.

Effect on an IRA account. Generally, if you or your beneficiary engages in a prohibited transaction in connection with your traditional IRA account at any time during the year, the account stops being an IRA as of the first day of that year.

Effect on you or your beneficiary. If you or your beneficiary engages in a prohibited transaction in connection with your traditional IRA account at any time during the year, you (or your beneficiary) must include the fair market value of all 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 have to pay the 10% tax on early distributions, discussed later.

Borrowing on an annuity contract. If you borrow money against your traditional 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 have to pay the 10% additional tax on early distributions, discussed later.

Pledging an account as security. If you use a part of your traditional 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 early distributions, discussed later.

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 the employee association with whom you have your traditional IRA engages in a prohibited transaction.

Owner participation. If you participate in the prohibited transaction with your employer or the association, your account is no longer treated as an IRA.

Taxes on prohibited transactions. If someone other than the owner or beneficiary of a traditional IRA engages in a prohibited transaction, that person may be liable for certain taxes. In general, there is a 15% tax on the amount of the prohibited transaction and a 100% additional tax if the transaction is not corrected.

Loss of IRA status. If the traditional 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 under Effect on you or your beneficiary, earlier.

Exemptions From Penalties

Exemption from prohibited transaction penalties has been granted for the following two transactions, if they meet the requirements listed later under Payments of cash, property, or other consideration and Services received at reduced or no cost.

• Payments of cash, property, or other consideration by the sponsor of your traditional IRA to you (or members of your family).
• Your receipt of services at reduced or no cost from the bank where your traditional IRA is established or maintained.

Payments of cash, property, or other consideration. Even if a sponsor makes payments to you or your family, there is no prohibited transaction penalty if all three of the following requirements are met.

1. The payments are for establishing a traditional IRA or for making additional contributions to it.
2. The IRA is established solely to benefit you, your spouse, and your or your spouse's beneficiaries.
3. During the year, the total fair market value of the payments you receive is not more than:
1. $10 for IRA deposits of less than $5,000, or
2. $20 for IRA deposits of $5,000 or more.

If the consideration is group term life insurance, requirements (1) and (3) do not apply if no more than $5,000 of the face value of the insurance is based on a dollar-for-dollar basis on the assets in your IRA.

Services received at reduced or no cost. Even if a sponsor provides services at reduced or no cost, there is no prohibited transaction penalty if all five of the following requirements are met.

1. The traditional IRA qualifying you to receive the services is established and maintained for the benefit of you, your spouse, and your or your spouse's beneficiaries.
2. The bank itself can legally offer the services.
3. The services are provided in the ordinary course of business by the bank (or a bank affiliate) to customers who qualify but do not maintain an IRA (or a Keogh plan).
4. The determination, for a traditional IRA, of who qualifies for these services is based on an IRA (or a Keogh plan) deposit balance equal to the lowest qualifying balance for any other type of account.
5. The rate of return on a traditional IRA investment that qualifies is not less than the return on an identical investment that could have been made at the same time at the same branch of the bank by a customer who is not eligible for (or does not receive) these services.

Investment in Collectibles

If your traditional IRA invests in collectibles, the amount invested is considered distributed to you in the year invested. You may have to pay the 10% tax on early distributions, discussed later.

Collectibles. These 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. It can also invest in certain platinum coins and certain gold, silver, palladium, and platinum bullion.

Excess Contributions

Generally, an excess contribution is the amount contributed to your traditional IRAs that is more than the smaller of:

1. Your taxable compensation for the year, or
2. $2,000 for 2001 ($3,000 for 2002 or $3,500 for 2002 if 50 or older).

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 3, later.

Tax on Excess Contributions

In general, if the excess contribution for a year and any earnings on it are not withdrawn by the date your return for the year is due (including extensions), you are subject to a 6% tax. You must pay the 6% tax each year on excess amounts that remain in your traditional IRA at the end of your tax year. 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 2001, 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 2001 and $6 interest in 2002 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 for 2001 by multiplying the excess contribution ($500) shown on line 16, Form 5329, by .06, giving him an additional tax liability of $30. He enters the tax on line 17, Form 5329, and on line 55, Form 1040. See Paul's filled-in Form 5329.

Form 5329, page 1 Paul Jones

Excess Contributions Withdrawn by Due Date of Return

You will not have to pay the 6% tax if you withdraw an excess contribution made during a tax year and you also withdraw any interest or other income earned on the excess contribution. You must complete your withdrawal by the date your tax return for that year is due, including extensions.

How to treat withdrawn contributions. Do not include in your gross income an excess contribution that you withdraw from your traditional IRA before your tax return is due if both of the following conditions are met.

1. No deduction was allowed for the excess contribution.
2. You withdraw the interest or other income earned on the excess contribution.

You can take into account any loss on the contribution while it was in the IRA when calculating the amount that must be withdrawn. If there was a loss, the net income you must withdraw may be a negative amount.

Note. If the trustee of your IRA is unable to calculate the amount you must withdraw, get IRS Notice 2000-39. The notice explains the IRS-approved method of calculating the amount you must withdraw. To obtain a copy of this notice, see Mail in chapter 5. This notice can also be found in many libraries and IRS offices.

How to treat withdrawn interest or other income. 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 distributions, 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, the form will indicate the year in which the earnings are taxable.

Example. Maria, age 35, made an excess contribution in 2001 of $1,000, which she withdrew by April 15, 2002, the due date of her return. At the same time, she also withdrew the $50 income that was earned on the $1,000. She must include the $50 in her gross income for 2001 (the year in which the excess contribution was made). She must also pay an additional tax of $5 (the 10% tax on early distributions because she is not yet 59 1/2 years old), but she does not have to report the excess contribution as income or pay the 6% excise tax. Maria receives a Form 1099-R showing that the earnings are taxable for 2001.

Excess Contributions Withdrawn After Due Date of Return

In general, you must include all distributions (withdrawals) from your traditional IRA in your gross income. However, if the following conditions are met, you can withdraw excess contributions from your IRA and not include the amount withdrawn in your gross income.

1. Total contributions (other than rollover contributions) for 2001 to your IRA were not more than $2,000.
2. You did not take a deduction for the excess contribution being withdrawn.

The withdrawal can take place at any time, even after the due date, including extensions, for filing your tax return for the year.

Excess contribution deducted in an earlier year. If you deducted an excess contribution in an earlier year for which the total contributions were $2,000 or less, you can still remove the excess from your traditional 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 traditional IRA is the result of a rollover and the excess occurred because the information the plan was required to give you was incorrect, you can withdraw the excess contribution. The limits mentioned above are 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 the part of the excess contribution caused by the incorrect information.

Deducting an Excess Contribution in a Later Year

You cannot apply an excess contribution to an earlier year even if you contributed less than the maximum amount allowable for the earlier year. However, you may be able to 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 excess contributions for previous years that are still in your traditional IRA. The amount you can deduct this year is the lesser of the following two amounts.

1. Your maximum IRA deduction for this year minus any amounts contributed to your traditional IRAs for this year.
2. The total excess contributions in your IRAs at the beginning of this 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.

To figure the amount of excess contributions for previous years that you can deduct this year, see Worksheet 1-4.

Worksheet 1-4. Excess Contributions Deductible This Year

Use this worksheet to figure the amount of excess contributions from prior years you can deduct this year.

Example. Terry was entitled to contribute to her traditional IRA and deduct $1,000 in 2000 and $1,500 in 2001 (the amounts of her taxable compensation for these years). For 2000, she actually contributed $1,400 but could deduct only $1,000. In 2000, $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 2000 return. Since Terry did not withdraw the excess, she owes excise tax of $24 for 2000. To avoid the excise tax for 2001, she can correct the $400 excess amount from 2000 in 2001 if her actual contributions are only $1,100 for 2001 (the allowable deductible contribution of $1,500 minus the $400 excess from 2000 she wants to treat as a deductible contribution in 2001). Terry can deduct $1,500 in 2001 (the $1,100 actually contributed plus the $400 excess contribution from 2000). This is illustrated by Filled-in Worksheet 1-4.

Filled-in Worksheet 1-4. Example of Excess Contributions Deductible This Year

Use this worksheet to figure the amount of excess contributions from prior years you can deduct this year.

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 a traditional 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.

To figure the amount of excess contributions for previous years that you can deduct this year if you incorrectly deducted part of the excess contribution in a closed tax year, see Worksheet 1-5.

Worksheet 1-5. Excess Contributions Deductible This Year if Any Were Deducted in a Closed Tax Year

Use this worksheet to figure the amount of excess contributions for prior years that you can deduct this year if you incorrectly deducted excess contributions in a closed tax year.

Early Distributions

You must include early distributions of taxable amounts from your traditional IRA in your gross income. Early distributions are also subject to an additional 10% tax, as discussed later.

Early distributions defined. Early distributions are amounts distributed from your traditional 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 situations, you may not have to pay the 10% additional tax even if amounts are distributed from your IRA before you are age 59 1/2. These situations are listed below.

• You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income.
• The distributions are not more than the cost of your medical insurance.
• You are disabled.
• You are the beneficiary of a deceased IRA owner.
• You are receiving distributions in the form of an annuity.
• The distributions are not more than your qualified higher education expenses.
• You use the distributions to buy, build, or rebuild a first home.
• The distribution is due to an IRS levy of the qualified plan.

Most of these exceptions are explained earlier at Exceptions under Age 59 1/2 Rule.

Note. Distributions that are timely and properly rolled over, as discussed earlier, are not subject to either regular income tax or the 10% additional tax. Certain withdrawals of excess contributions are also tax free and not subject to the 10% additional tax. (See Excess Contributions, earlier.) This also applies to transfers incident to divorce, as discussed under Can I Move Retirement Plan Assets, earlier.

Receivership distributions. Early distributions (with or without your consent) from savings institutions placed in receivership are subject to this tax unless one of the above exceptions applies. This is true even if the distribution is from a receiver that is a state agency.

Additional 10% tax. The additional tax on early distributions is 10% of the amount of the early distribution that you must include in your gross income. This tax is in addition to any regular income tax resulting from including the distribution in income.

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 Jones, who is 35 years old, receives a $3,000 distribution from his traditional IRA account. Tom does not meet any of the exceptions to the age 59 1/2 rule, so the $3,000 is an early distribution. Tom never made any nondeductible contributions to his IRA. He must include the $3,000 in his gross income for the year of the distribution and pay income tax on it. Tom must also pay an additional tax of $300 (10% × $3,000). He chooses to file Form 5329. See the filled-in Form 5329.

Form 5329, page 1 Tom Jones

Early distributions of funds from a SIMPLE retirement account made within 2 years of beginning participation in the SIMPLE are subject to a 25%, rather than 10%, early distributions tax.

Nondeductible contributions. The tax on early distributions does not apply to the part of a distribution that represents a return of your nondeductible contributions (basis).

Excess Accumulations (Insufficient Distributions)

You cannot keep amounts in your traditional IRA indefinitely. Generally, you must begin receiving distributions by April 1 of the year following the year in which you reach age 70 1/2 (your 70 1/2 year). The minimum required distribution for any year after your 70 1/2 year must be made by December 31 of that later year.

Tax on excess. If distributions are less than the minimum required distribution for the year, discussed earlier under When Must I Withdraw IRA Assets? (Required Distributions), you may have to pay a 50% excise tax for that 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.

If you believe you qualify for this relief, do the following.

1. File Form 5329 with your Form 1040.
2. Pay any tax you owe on excess accumulations.
3. Attach a letter of explanation.

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 a traditional 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. Revenue Procedure 92-10 is in Cumulative Bulletin 1992-1. To obtain a copy of this revenue procedure, see Mail in chapter 5. You can also read the revenue procedure at most IRS offices and at many public libraries.

Conditions. To qualify for exemption from the tax, the assets in your traditional IRA must include an affected investment. Also, the amount of your required distribution must be determined as discussed earlier under Minimum Distributions.

Affected investment defined. 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 traditional IRA (or IRAs) includes other assets in addition to your affected investment, all traditional IRA assets, including the available portion of your affected investment, must be used to satisfy as much as possible your IRA distribution requirement. If the affected investment is the only asset in your IRA, as much as possible of the required distribution 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 by December 31 of the calendar year following the year that you receive increased payments.

Reporting Additional Taxes

Generally, you must use Form 5329 to report the tax on excess contributions, early (premature) distributions, and excess accumulations.

Filing Form 1040. 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 55, Form 1040.

Note. If you have to file an individual income tax return and Form 5329, you must use Form 1040.

Not filing 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 the IRS at the time and place you would have filed Form 1040. Be sure to include your address on page 1 and your signature and date on page 2. Enclose, but do not attach a check or money order payable to the United States Treasury for the tax you owe, as shown on Form 5329. Write your social security number and "2001 Form 5329" on your check or money order.

Form 5329 not required. You do not have to use Form 5329 if any of the following conditions exist.

• Distribution code 1 (early distribution) is shown in box 7 of Form 1099-R. If you do not owe any other additional tax on a distribution, multiply the taxable part of the early distribution by 10% and enter the result on line 55 of Form 1040. Write "No" next to line 55 to indicate that you do not have to file Form 5329. However, if you owe this tax and also owe any other additional tax on a distribution, do not enter this 10% additional tax directly on your Form 1040. You must file Form 5329 to report your additional taxes.
• You qualify for an exception to the additional tax on early distributions. You do not have to report the exception if distribution code 2, 3, or 4 is shown in box 7 of Form 1099-R. However, if one of those codes is not shown, or the code shown is incorrect, you must file Form 5329 to report the exception.
• You properly rolled over all distributions you received during the year.

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