Are Nondeductible Contributions in a IRA Subject to Early Withdrawal Penalties?
IRAs, or individual retirement arrangements, are tax-deferred retirement accounts. Investing in an IRA allows you to postpone paying taxes on the funds in your account until you withdraw the money. Since many people are in a lower tax bracket when they retire and start taking money out of their IRAs, there is often a net tax savings with an IRA.
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IRA Contributions
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The IRS has rules regarding how much you can contribute to an IRA. The 2010 contribution limit for people under 50 years of age is $5,000 or their taxable compensation, whichever is less. People aged 50 years or older can contribute up to the lesser of $6,000 or their taxable compensation. You cannot contribute to an IRA starting in the year you turn 70 ½ (if you turn 70 in March, you will turn 70 ½ in September of the same year; if you turn 70 in July, however, you will turn 70 ½ the next year). This limit applies across all of your IRAs.
Non-Deductible IRA Contributions
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Congress established IRAs in 1974 to benefit those who were not eligible for employer-sponsored retirement plans. To match the tax advantages of employer plan pre-tax contributions, most IRA contributions are tax-deductible. If you or your spouse are eligible for an employer's retirement plan, however, your IRA deduction may be restricted; you can receive a tax benefit from your employer plan, so you are not able to receive a second benefit for an IRA contribution. You can still contribute to an IRA, up to the limit, but you cannot deduct the contribution on your tax return.
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Rollover IRA Contributions
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A rollover contribution occurs when you withdraw money from one IRA and deposit it into another IRA within 60 days. If you do not re-deposit the funds within that time frame, the distribution is subject to taxes and penalties. A direct rollover occurs when money from a qualified account, such as a 401k, is transferred directly into an IRA. Moving money directly from one IRA to another is called a trustee-to-trustee transfer. IRA contribution limits do not apply to rollovers or transfers and as long as the time limit is met on a rollover the money is not taxable.
IRA Distributions
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IRS rules only permit withdrawals from an IRA, called distributions, for taxpayers aged 59 ½ or older. Taxpayers aged 70 ½ or older are required to take a percentage of their account balance as a distribution each year. IRA distributions are taxable in the year you withdraw the money. The exception is the portion of a distribution that represents a return of non-deductible IRA contributions, which is money that has already been taxed. Earnings on deductible contributions, however, are taxed when they are withdrawn.
Early Distributions From an IRA
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If the taxpayer is younger than 59 ½, a withdrawal is called an early distribution. To discourage spending the money on something other than retirement, the IRS imposes a 10% penalty to early distributions from an IRA. The IRS allows a few exceptions to the early withdrawal penalty, such as distributions to pay certain medical expenses, qualified higher education expenses or first-time home purchases. The 10% early withdrawal penalty does not apply to a return of non-deductible IRA contributions, which money has already been taxed, but does apply to any earnings on those contributions, which are tax-deferred.
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