Sometimes, the amount of taxes will be zero. However, in other cases, you will owe income tax on the money you withdraw and sometimes an additional penalty, if you withdraw funds before age 59½. After a certain age, you may be required to withdraw money and pay taxes on it.
Investopedia’s recent article, “How Much are Taxes on an IRA Withdrawal?” says there are a number of IRA options, but the Roth IRA and the traditional IRA are the most frequently used types. The withdrawal rules for other types of IRAs are similar to the traditional IRA, but with some minor unique differences. The other types of IRAs—the SEP-IRA, Simple IRA, and SARSEP IRA—have different rules about who can start one.
Your investment in a Roth IRA is with money after it’s already been taxed. When you withdraw the money in retirement, you don’t pay tax on the money you withdraw or on any gains you made on your investments. That’s a big benefit. To use this tax-free withdrawal, the money must have been deposited in the IRA and held for at least five years, and you have to be at least 59½ years old.
If you need the money before that, you can take out your contributions without a tax penalty, provided you don't use any of the investment gains. You should keep track of the money withdrawn prior to age 59½, and tell the trustee to use only contributions, if you’re withdrawing funds early. If you don’t do this, you could be charged the same early withdrawal penalties charged for taking money out of a traditional IRA. For a retired investor who has a 401(k), a little-known technique can allow for a no-strings-attached withdrawal of a Roth IRA at age 55 without the 10% penalty: the Roth IRA is “reverse rolled” into the 401(k) and then withdrawn under the age 55 exception.
Money deposited in a traditional IRA is treated differently, because you deposit pre-tax income. Every dollar you deposit decreases your taxable income by that amount. When you withdraw the money, both the initial investment and the gains it earned are taxed. But if you withdraw money before you reach age 59½, you’ll be assessed a 10% penalty in addition to regular income tax based on your tax bracket. There are some exceptions to this penalty. If you accidentally withdraw investment earnings rather than only contributions from a Roth IRA before you are 59½, you can also owe a 10% penalty. You can, therefore, see how important it is to maintain careful records.
There are some hardship exceptions to penalty charges for withdrawing money from a traditional IRA or the investment portion of a Roth IRA before you hit age 59½. Some of the common exceptions include:
- A required distribution in a divorce;
- Qualified education expenses;
- A qualified first-time home purchase;
- The total and permanent disability or the death of the IRA owner;
- Unreimbursed medical expenses; and
- The call to duty of a military reservist.
Another way to avoid the tax penalty, is if you make an IRA deposit and change your mind by the extended due date of that year's tax return, you can withdraw it without owing the penalty (but that cash will be included in the year's taxable income). The other time you risk a tax penalty for early withdrawal, is when you’re rolling over the money from one IRA into another qualified IRA. Work with your IRA trustee to coordinate a trustee-to-trustee rollover. If you make a mistake, you may end up owing taxes.
With IRA rollovers, you can only do one per year where you physically remove money from an IRA, receive the proceeds and within 60 days subsequently deposit the funds in another IRA. If you do a second, it’s 100% taxable.
You shouldn’t mix Roth IRA funds with the other types of IRAs, because the Roth IRA funds will be taxable.
When you hit 59½, you can withdraw money without a 10% penalty from any type of IRA. If it’s a Roth IRA, you won't owe any income tax. If it's not, there will be a tax. If the money is deposited in a traditional IRA, SEP IRA, Simple IRA, or SARSEP IRA, you’ll owe taxes at your current tax rate on the amount you withdraw.
Once you reach age 70½, you will need to take a Required Minimum Distribution (RMD) from a traditional IRA. The IRS has specific rules as to the amount of money you must withdraw each year. If you don’t withdraw the required amount, you could be charged a 50% tax on the amount not distributed as required. You can avoid the RMD completely, if you have a Roth IRA because there aren’t any RMD requirements. However, if money remains after your death, your beneficiaries may have to pay taxes.
The money you deposit in an IRA should be money you plan to use for retirement. However, sometimes there are unexpected circumstances. If you’re considering withdrawing money before retirement, know the rules for IRA penalties, and try to avoid that extra 10% payment to the IRS.
If you think you may need emergency funds before retirement, use a Roth IRA for those funds, and not a traditional IRA.
While making these decisions, it is also important to think about who you want to inherit for IRA and what the best way for them to inherit it may be. Speak with an experienced Estate Planning Attorney to learn how a specific type of trust can be used to help protect your IRA beneficiaries. Call Rowley Law today, at 847-490-5330, to schedule an appointment.
Reference: Investopedia (February 9, 2019) “How Much are Taxes on an IRA Withdrawal?”