Tax-favored accounts make sense because they offer a way to save for the future and save on taxes at the same time. Put your money in a savings account and that’s a step up from doing nothing. Put your money into a tax-favored account and that’s a step higher. Why? Because the money you put into a tax-favored account (called your contributions) is money you won’t have to pay taxes on, at least not just yet.
Here’s an example: you put money into an IRA …if it’s a Roth IRA, you won’t pay income tax on the money you take out after the age of 59 1/2. It’s a way of helping yourself out in retirement…pay the taxes now so you won’t have to later. You’ve already paid the taxes now because the money came from your current income, which is taxed.
1. There are Rules About Using Money in a Tax-Favored Account
But if you withdraw that IRA money before you hit age 59 1/2, you pay a penalty. You’ll have to pay an additional 10% tax on the distribution. It’s called an early distribution when you withdraw money from a tax-favored account that’s supposed to remain intact until its designated purpose.
2. If You Break Those Rules, You Have to Tell the IRS About It
Tax-favored accounts come in all sorts of shapes and sizes. Some are for retirement, some are for medical expenses, and others are for education. The general idea is, you are encouraged to save money for these important life events that require large amounts of cash. The encouragement comes in the shape of a tax break…hence the label tax-favored account. If you use the money for something other than the designated purpose, you are taking an early distribution. You will have to fill out and submit IRS Form 5329 and ‘fess up to the IRA about breaking the rules of the tax-favored account you had.
3. Not Only Do You Have to Tell the IRS You Broke the Rules, You’ll Also Have to Pay a Fine or a Tax
Also, you’ll be paying some sort of penalty or tax, as well. There’s an Additional Tax on early withdrawals from your IRA, for example. It’s 10%.
4. Tax-Favored Accounts Can Actually be Worse Than Doing Nothing At All
If you break the rules, that is. That’s because of above-mentioned additional taxes and penalties. So think carefully if you are considering a tax-favored account. If you can think of any reason at all where you’d be likely to need that money for something else, you’d be better off doing nothing at all with your cash than just leaving it in a savings account.
5. It’s Possible to Break the Rules in Many Different Ways
You can even break the rules by contributing too much to your tax-favored account. There are contribution limits to IRAs and such. If you put in too much, again you’ll have to file IRS Form 5329 and pay an additional tax.
Here’s a link to IRS Form 5329 and the instructions that go with it. Make sure you know the conditions of a tax-favored account before setting one up so you don’t have to pay additional tax or other penalties.