How to Avoid Paying Tax on an IRA Withdrawal
Retirement account owners frequently worry about how much tax they owe if they withdraw funds prior to turning 59 1/2, but there are ways they can minimize or avoid penalties associated with early withdrawal.
Rules may differ based on your tax situation and type of IRA account you hold, so here are a few strategies that could help avoid penalties:
1. Take a Distribution in a Low-Income Year
Financial advisors are constantly searching for strategies that can help their clients avoid paying taxes on IRA withdrawals, but each case varies. Before making any decisions or implementing strategies on your own, it’s best to consult a qualified advisor – SmartAsset’s free advisor matching tool can connect you with local advisors who serve your area.
Under normal circumstances, an early withdrawal penalty tax of 10% applies on any distributions from traditional, SEP and SIMPLE IRAs prior to age 59 1/2 unless an exception applies. This applies whether these funds come from traditional, SEP or SIMPLE accounts.
But in certain special circumstances, you can take penalty-free distributions from your IRA. Examples include military service, college expenses for yourself or family members (such as tuition, fees, room and board and books and supplies), large unreimbursed medical expenses or first-time home purchases. To be eligible, calculate a fraction with the numerator being nondeductible contributions and the denominator being your total balances on withdrawal date.
2. Take a Distribution in a Tax Year
If you make substantially equal periodic payments (SEPPs) over five years or reach age 59 1/2, withdrawals from an IRA without incurring the 10% penalty are available to you without additional restrictions or exceptions; examples may include first-time homebuyers, unreimbursed medical expenses exceeding 7.5% of adjusted gross income and distributions made to cover higher education costs.
If your IRA contains both tax-deductible contributions and after-tax contributions, it is important to calculate what proportion of withdrawal or conversion is comprised by nondeductible contributions in order to avoid early withdrawal penalties. Doing this properly while keeping accurate records can help avoid early withdrawal penalties; so working with an advisor or professional might also be useful in doing this calculations correctly and avoid unnecessary early withdrawal fees.
As soon as you turn 70 1/2, it is mandatory that you begin taking RMDs from your traditional IRA and other retirement accounts. Your RMD is calculated by dividing your account balance by your estimated life expectancy using IRS tables; an efficient method for meeting RMD is usually an IRA rollover; however if this strategy is employed be wary of its 60-day tax deadline.
3. Take a Distribution in a Low-Income Year with a Rollover
Before using any legal strategies to avoid paying taxes on an IRA withdrawal, it’s a good idea to consult a financial advisor to make sure they suit your personal situation and vision for retirement. SmartAsset’s free advisor matching tool can help you locate one who can offer guidance tailored specifically to you and your goals.
Typically, when withdrawing funds from an individual retirement account (IRA) or workplace plan like a 401(k), you’ll owe income tax plus a 10% penalty. There are exceptions such as using withdrawals to cover unreimbursed medical expenses and permanent disability or death withdrawals from an IRA; plus you may avoid the penalty by rolling over distributions including after-tax contributions into another IRA within 60 days – to qualify under this exception, track how many after-tax contributions were received each year to qualify under this exception.
4. Take a Distribution in a Tax Year with a Rollover
There are various strategies available to you for avoiding tax on an IRA withdrawal, though some can be more complex than others. Consult a certified financial professional in order to avoid any pitfalls.
One strategy for avoiding taxes is conducting a direct rollover from your former employer’s retirement account to your new one, which enables you to maintain its tax advantages while protecting you from potential penalties associated with missed RMDs.
One way to avoid taxes is to take substantially equal periodic payments (SEPPs) over five years or until age 59 1/2, using amortizing tables from the Internal Revenue Service as a guideline. These withdrawals act like annuity payments that reduce tax liability.
SEPPs also allow you to withdraw money penalty-free if it’s used to cover qualified medical expenses that exceed 7.5% of adjusted gross income, employee business expenses unreimbursed by employers and first time home purchases. But you must adhere exactly to your withdrawal schedule or risk incurring a 10% penalty tax penalty tax penalty tax penalty tax penalty tax penalty tax penalty tax penalty.
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