What Acts Result in Penalties or Additional Taxes?

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 your account stops being an IRA because you or your beneficiary engaged in a prohibited transaction, the account is treated as distributing all its assets to you at their fair market values on the first day of the year. If the total of those values is more than your basis in the IRA, you will have a taxable gain that is includible in your income. For information on figuring your gain and reporting it in income, see Are Distributions Taxable, earlier. The distribution may be subject to additional taxes or penalties.

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 for the year that is more than the smaller of:

1. Your taxable compensation for the year, or
2. $3,000 ($3,500 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 contributions for a year 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 additional tax is figured on Form 5329. For information on filing Form 5329, see Reporting Additional Taxes, later.

Example. For 2002, Paul Jones is 45 years old and single, his compensation is $31,000, and he contributed $3,500 to his traditional IRA. Paul has made an excess contribution to his IRA of $500 ($3,500 minus the $3,000 limit). The contribution earned $5 interest in 2002 and $6 interest in 2003 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 additional tax for 2002 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 58, 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 or section 1.408-4(c) of the proposed regulations. These explain the IRS-approved method of calculating the amount you must withdraw. To obtain a copy of this notice, see Mail in chapter 6. This proposed regulation is published in 2002-33 Internal Revenue Bulletin at page 383. This notice and proposed regulation 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 2002 of $1,000, which she withdrew by April 15, 2003, 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 2002 (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 2002.

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 2002 to your IRA were not more than $3,000 ($3,500 if 50 or older).
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.

1.	Maximum IRA deduction for the current year	1.
2.	IRA contributions for the current year	2.
3.	Subtract line 2 from line 1. If zero (0) or less, enter zero	3.
4.	Excess contributions in IRA at beginning of year	4.
5.	Enter the lesser of line 3 or line 4. This is the amount of excess contributions for previous years that you can deduct this year	5.

Worksheet 1-4. Excess Contributions Deductible This Year"> Example. Terry was entitled to contribute to her traditional IRA and deduct $1,000 in 2001 and $1,500 in 2002 (the amounts of her taxable compensation for these years). For 2001, she actually contributed $1,400 but could deduct only $1,000. In 2001, $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 2001 return. Since Terry did not withdraw the excess, she owes excise tax of $24 for 2001. To avoid the excise tax for 2002, she can correct the $400 excess amount from 2001 in 2002 if her actual contributions are only $1,100 for 2002 (the allowable deductible contribution of $1,500 minus the $400 excess from 2001 she wants to treat as a deductible contribution in 2002). Terry can deduct $1,500 in 2002 (the $1,100 actually contributed plus the $400 excess contribution from 2001). 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.

1.	Maximum IRA deduction for the current year	1.	1,500
2.	IRA contributions for the current year	2.	1,100
3.	Subtract line 2 from line 1. If zero (0) or less, enter zero	3.	400
4.	Excess contributions in IRA at beginning of year	4.	400
5.	Enter the lesser of line 3 or line 4. This is the amount of excess contributions for previous years that you can deduct this year	5.	400

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.

1.	Maximum IRA deduction for the current year	1.
2.	IRA contributions for the current year	2.
3.	If line 2 is less than line 1, enter any excess contributions that were deducted in a closed tax year. Otherwise, enter zero (0)	3.
4.	Subtract line 3 from line 1	4.
5.	Subtract line 2 from line 4. If zero (0) or less, enter zero	5.
6.	Excess contributions in IRA at beginning of year	6.
7.	Enter the lesser of line 5 or line 6. This is the amount of excess contributions for previous years that you can deduct this year	7.

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