Penalties for Moving IRA Funds

Taxpayers may deduct contributions to their traditional IRAs when they file their income tax returns.

Prior to the passage of the Employee Retirement Income Security Act of 1974 self-employed individuals had little opportunity for setting aside funds for retirement in a tax-advantaged account. ERISA provided for the creation of individual retirement accounts for self-employed taxpayers and for employees who worked for companies that did not offer a qualified retirement plan. More recent legislation extended the availability of IRAs to most taxpayers who have earned income, but there are limitations to the benefits of IRAs, including substantial penalties for early withdrawals.

IRA Basics

There are two basic types of IRAs. Under a traditional IRA, contributions are tax deductible, investments grow tax-deferred inside the account and qualified distributions are taxed as ordinary income. With the Roth IRA, contributions are made with after-tax dollars, investment growth is still not taxed within the plan and qualified distributions are tax-free. In both cases, with few exceptions, distributions taken before the owner reaches age 59 1/2 are not only taxed, but a 10 percent penalty on distributions also applies. Roth IRAs carry the additional requirement that the owner must have had it for at least five years before taking distributions.

Trustee-to-Trustee Transfer

Many IRA trustees offer a variety of investments that an account holder may choose from. An account holder may move some or all of the funds in her IRA between investments offered by her trustee without incurring a tax penalty. Some trustees, such as some mutual fund companies, will also waive the transfer fee between mutual funds within their family of funds. An IRA account holder may request a direct transfer of her money from one trustee to another. This type of transaction, referred to as a trustee-to-trustee transfer does not involve the account holder taking possession of her IRA funds, so there is no penalty involved.

Roth Conversion

Some taxpayers may benefit from converting their traditional IRAs into Roth IRAs. The taxpayer must contribute any amounts withdrawn from her traditional IRA into her Roth IRA within 60 days of receiving the distribution to avoid the 10 percent tax penalty. The taxpayer will still have to pay ordinary income tax on any amounts removed from her traditional IRA, since she received a tax deduction when she made her original contribution. Income taxes apply to both the contributions and any growth that occurred within the traditional IRA.

Rollover

Funds in a traditional IRA may be moved into other types of qualified retirement accounts, such as a different IRA or a 401k plan, without resulting in the normal 10 percent tax penalty through a process called a rollover. Once funds from an IRA are disbursed to the account holder, she has 60 days to roll the funds over into another qualified plan, or she will be liable for income taxes and the tax penalty. In most cases the original IRA trustee will withhold 20 percent of the account value as insurance against the IRA owner not completing the transfer. The IRA owner will be required to make up that 20 percent until she files her her federal income taxes.

References

• Internal Revenue Service: Publication 590 Individual Retirement Arrangements
• Internal Revenue Service: Retirement Topics - Tax on Early Distributions
• Internal Revenue Service: Retirement Plans FAQs regarding IRAs
• Internal Revenue Service: Topic 557 - Tax on Early Distributions from Traditional and ROTH IRAs
• Bankrate: 7 steps to a 2010 Roth IRA conversion Read more: 7 Steps to a 2010 Roth IRA Conversion, Amy E. Buttell,

Resources

• Bankrate: IRS Rules for Early IRA Withdrawals, Kay Bell, Updated: March 13, 2008
• Congressional Budget Office: Legislative History of IRAs