How to Avoid Tax on IRA Withdrawal
Withdrawals made before age 59 1/2 will usually incur income tax and a 10% penalty; however, exceptions exist, including first-time home purchases and qualified higher education expenses.
Traditional IRAs are funded with pretax earnings while Roth IRA contributions come out of after-tax dollars, though there are ways you may be able to avoid taxes when withdrawing your savings from either one.
1. Take a Distribution in a Low-Income Year
Once you turn age 59 1/2, withdrawals from traditional IRAs can be taken without penalty; any withdrawals prior to that point will incur taxes unless one of several exceptions applies.
One way to avoid penalties is to take your RMD during a lower income year, but for this to work properly you must keep careful records of after-tax contributions to IRAs, and calculate their ratio between nondeductible and deductible contributions each time you calculate your RMDs.
If you have an eye for charity, considering making a qualified charitable distribution (QCD). With this strategy you can transfer up to $100,000 directly from your IRA each year without it appearing in your adjusted gross income – an especially useful strategy since fewer people itemize deductions now. Furthermore, using funds in an IRA as downpayment on your first home purchase costs without incurring penalties can also be done without penalty.
2. Take a Distribution for a First-Time Home Purchase
At the heart of it all lies tax avoidance for your IRA distribution planning, though that’s often not possible. Most IRAs are funded using pre-tax dollars so any distribution you take from it will likely be taxed, though there are ways you can use to minimize any tax payments you owe.
Most individuals who take early withdrawals from an IRA before reaching age 59 1/2 will incur the 10% early withdrawal penalty, though you may be exempt if using it to purchase their first home (up to $10,000), pay medical expenses that exceed 7.5% of income, or purchase disability insurance following job loss.
Roth accounts don’t carry penalties when withdrawing funds because taxes were already paid when that money entered your Roth account. By contrast, withdrawals from traditional accounts count towards your “combined income” when filing for Social Security benefits.
3. Take a Distribution for Other Purposes
Taken tax into consideration, withdrawing funds from an IRA can be tricky business. But you can minimize tax liabilities with smart strategies recommended by advisors – before acting upon these recommendations, however, make sure you discuss them with one and see how they might fit with your circumstances – use SmartAsset’s free advisor matching tool to find one in your area.
Traditional IRAs and 401(k)s mandate taking required minimum distributions (RMDs), at a specific age. Failure to do so could incur penalties which can be very steep.
RMDs aren’t the only time when withdrawing funds from an IRA: medical costs, home purchase or satisfying a divorce court order may require withdrawing money as well. Withdrawals made under these circumstances could help avoid penalties; as an example, first-time home buyers are eligible to withdraw up to $10,000 without penalty fees being assessed against them.
4. Donate Part of Your IRA to Charity
An individual withdrawing their IRA funds as they near retirement could face high taxes depending on their individual circumstances and type of account; traditional IRA withdrawals are taxed as income while Roth IRA withdrawals do not.
An exemption to the penalty exists if an IRA owner donates part of his or her account to charity via qualified charitable distribution (QCD), however only an IRA account can make such donations; to avoid penalties the donor must use his/her IRA account directly transfer funds directly to a qualified charity account within that IRA account.
An IRA owner can avoid the 10% penalty by listing life insurance as their beneficiary instead of family members as the beneficiaries for his or her IRA, and passing it along tax free when their decedent dies before age 59 1/2; their beneficiaries can take full withdrawals without penalty as death benefits don’t count towards taxable income; however, beneficiaries who inherit their IRA must pay income tax on withdrawals used other than medical purposes.
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