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Traditional IRA Withdrawal Rules – Strategies To Pay Less

Traditional IRA Withdrawal Rules – Strategies To Pay Less

Using a traditional IRA to boost your tax-deferred savings for retirement is one of the smartest ways to set aside money for your retirement. Since most of your IRA contributions will come from your pre-tax income, you will inevitably need to pay taxes on your disbursements and withdrawals. There are some additional fees and penalties that will need to be addressed, however, should you decide to take on an early withdrawal.

While you will be able to start taking withdrawals penalty-free, starting at age 59 ½, the most popular strategy for avoiding taxes as long as possible is to wait until the required minimum withdrawals begin at age 72. There are additional ways to avoid early withdrawal penalties.

In addition to waiting as long as possible to begin IRA withdrawals, there are many other strategies for avoiding some of the penalties that are associated with IRA withdrawals, even if you haven't reached age 59 ½ yet. We are going to take a close look at the IRA withdrawal rules, the various penalties that are involved, as well as some ways that you may be able to avoid them.

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IRA Withdrawal Rules

Your traditional IRA is generally funded by contributions from a pre-tax income source, which means they are subject to taxes once you begin drawing on them at age 59 ½, but not later than age 72. One of the issues, however, is that occasionally someone may need to make an early withdrawal from their IRA, which may ordinarily be subject to a penalty as well as taxes.

The biggest rule regarding early withdrawals from a traditional IRA is that if you haven't reached age 59 ½, any early withdrawals will be subject to a penalty of 10% imposed by the US federal government. Depending on the state you live in, there may also be a state-imposed early withdrawal penalty. This means starting to draw on your IRA can mean you automatically lose at least 10% and potentially more while paying taxes on the full amount being withdrawn.

Once you reach 59 ½, there are no penalties for making an IRA withdrawal, nor are there any restrictions. These zero-penalty withdrawals can occur any time after age 59 ½, but if your contributions come from pre-tax income, don't forget that earnings and contributions that were deductible (which includes any capital gains, interest, or invested dividends) will be viewed as taxable income by the federal government.

This is why IRAs are referred to as a form of "tax deferral" since you don't avoid paying taxes; you merely defer those taxes until a later date. That's an important factor that many people don't consider when setting up their retirement account and determining whether they want to pay taxes on their money now or later.

Required Minimum Distributions

You can continue to leverage your tax deferral on contributions no matter your age. Be aware, however, that required minimum distributions, or RMDs, begin at age 72. The first required minimum distribution must be withdrawn by April 1st of the year after your 72nd birthday. If your 72nd birthday is on October 1st 2022, your first required minimum distribution must be taken by April 1st, 2023.

The amount of your required minimum distribution is determined by using the life expectancy factor determined by the IRS and dividing the total value of your IRA by that factor. This will be the absolute minimum amount you can withdraw, and if you fail to withdraw that amount, you will be penalized 50% of that amount. It turns into a "use it or lose it" situation incredibly quickly when you face the possibility of being penalized tens of thousands of dollars.

Withdrawal Strategies For Avoiding Early Withdrawal Penalties

In some specific circumstances, you may be able to take an early withdrawal from your traditional IRA without paying the standard 10% penalty. These situations are relatively uncommon, but they do allow you to gain access to your IRA funds before age 59 ½, provided you use them exactly as required by the circumstantial exceptions.

Purchasing Your First Home

If you are getting ready to buy your first home, you may be able to withdraw funds from your IRA early. There are some stipulations that go along with this, as only some types of home purchases will qualify. There is a lifetime limit of $10,000 of pre-tax IRA funds, and they must be used for that purpose within 6 months. Funds that are not used to buy a home within 120 days of the disbursement will be subject to standard penalties and any applicable taxes.

Health Insurance During Unemployment

You may be able to use an early withdrawal to pay for health insurance while you are unemployed. This penalty-free withdrawal must be used for health insurance, and can only be used if you are or will be unemployed for a minimum of 12 weeks. There are no other specified conditions that govern the type of insurance or the provider, and the funds can be used to purchase coverage for you, a spouse, and all dependents you care for.

Disability Or Death

If you become disabled, you can make penalty-free IRA withdrawals. Similarly, if you die, your beneficiaries will not face any penalties for IRA disbursements.

Active Military Service

Those who join the military or are called into active military service and subsequently serve for at least 180 days of active duty can take a penalty-free IRA withdrawal during their active service but not once the service has concluded.

Reservist Service

Military reservists and members of the National Guard can take a withdrawal if called into active service and remain active for at least 180. Just like with active military service, the withdrawal must happen during the service, after 180 days, but before active service has ended.

Birth Or Adoption Expenses

New parents can make a penalty-free withdrawal to pay for birth costs or adoption expenses. The withdrawal amount is capped at $5,000.

Paying For College Or University Expenses

A penalty-free withdrawal can be made to pay for expenses related to higher education for you or your family. This includes tuition costs, as well as books, supplies, and even room & board.

Payment Of Medical Bills

Individuals with outstanding medical bills that amount to more than 10% of their AGI, or adjusted gross income, can take penalty-free early withdrawals to pay.

Payment Of Federal Tax Liens

If you are facing a tax lien from the IRS placed on your property, a penalty-free IRA withdrawal can be used to pay that lien. This applies to both liens and back taxes, and if the withdrawal is due to an IRS levy, IRS Form 5329 will allow the individual paying the levy to claim the penalty exemption.

Donation Of Securities To Charity

If you make donations of securities from your IRA to an approved public charity, you will be able to claim a 30% tax deduction of the value of that donation. There is a $100,000 per year limit, but if the contribution exceeds that limit, it can be carried over for up to 5 years total.

401(k) Early Withdrawal Penalty

Just as with a traditional IRA, taking early withdrawals from your 401(k) can incur significant financial penalties. If you make a withdrawal or distribution from your 401(k) before the age of 59 ½, you will face several potential penalties, including:

  • 10% penalty on the full amount of the requested distribution
  • Federal income tax on the amount of the withdrawal, taxed at your existing marginal tax rate
  • Any relevant state income tax that may apply in your area

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Roth IRA Early Withdrawal Penalty

Your Roth IRA contributions are made with after-tax dollars, which lessens your tax liability during withdrawal since you've technically already paid taxes on those dollars. Being exempt from income tax during withdrawal, however, doesn't mean those funds are safe from penalties if you withdraw them early. The dollars you initially invested can create investment returns and capital gains, though, so you may still owe taxes in some circumstances.

An early withdrawal from your Roth IRA will be subject to the same 10% penalty set by the government. One difference between Roth IRA and a traditional IRA is that if you make a withdrawal that is greater than the after-tax dollars you contributed before the age of 59 ½, you will owe a 10% penalty on the full amount, as well as income tax on the amount greater than your initial contributions.

Also read: W-2 vs. W-4: Key Differences and When To Use Them

Understanding The Withdrawal Rules For Your IRA Can Help You Pay Less To Get Your Money

One of the biggest potential threats to your retirement funds is taking money out prematurely and having to take out even more than you need due to penalties. Being fully informed on exactly what those penalties are and avoiding them if it's at all possible is crucial to being able to retain as much of your initial retirement investment as you can. You're going to need it one day.

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