4 Ways to Avoid IRA Tax Traps

The IRA tax benefits are meant to encourage savings for retirement, but the accounts can present a financial disincentive at times. For example, there are limits on the types of assets that can be held in an IRA, caps on yearly contributions, and regulations regarding how much your funds can accumulate in an IRA. All told, it is not likely you will be able to save all you need for retirement using just one IRA account. Therefore, it is wise to devise creative strategies to avoid IRA tax traps and make your retirement savings work for you.

1. Place Tax-Efficient Assets Elsewhere

When you invest in a variety of funds, securities and investment options, you will have some that are more tax efficient than others. For example, real estate investments tend to be tax efficient because they are taxed as capital assets, and gains and losses can be deferred as a result. On the contrary, high-yield funds provide continual income, and this can be very inefficient during a given tax year. It is wise to place your least tax-efficient assets into your IRA. This way, the assets will be able to grow tax-deferred until you claim your distributions. For example, opt for an equity growth fund and place the fund in your IRA. You will not be taxed on gains as the fund grows.

2. Take Distributions as Soon as Possible

You may wait until you are 70 1/2 to begin taking distributions from your IRA. However, since IRAs limit the types of investments you can make, it is not wise to keep your money in the account any longer than you have to. You will have more flexibility if you take distributions starting at the qualified age of 59 1/2. Since you will have already received your tax benefits on the distributions, there is no real advantage to keeping them in the IRA at that point.

3. Reinvest IRA Distributions

When you do have a required minimum distribution (RMD), you may not need the funds immediately. You do not have the option of leaving the funds in the IRA, however. In order to keep saving, reinvest the funds elsewhere. This way you will not be assessed the 50 percent penalty for failing to take your distribution, but you will not diminish the size of your savings in the future if you do not need the income right this moment.

4. Remove Excess Contributions

You can be charged for an excess contribution if you either contribute too much to your fund or roll over an RMD. Neither is permitted, and you will be assessed a large penalty as a result. Do not let this money go to the IRS; instead, take advantage of the ability to withdraw the funds from the IRA immediately. If you do this before you file your yearly tax report, there will be no penalty on the excess. You can simply move the funds into another investment or savings account for the time being. You can always deposit the funds next year if your income is slightly lower and you need the extra money to contribute.