Income Taxes on IRA Withdrawals
An Individual Retirement Account (IRA) could be a suitable alternative if you lack access to workplace-based plans or desire more control over your investments, but be wary of potential tax consequences when making withdrawals from it.
When withdrawing funds from an IRA before age 59 1/2, taxes and penalties typically apply unless one of the exceptions apply.
What is an IRA?
An Individual Retirement Account, or IRA, allows you to invest pre-tax dollars tax-deferred and grow it tax-free over time. Depending on the type of IRA you own, distributions may be penalty-free under certain conditions. It allows for access to CDs, mutual funds, stocks and bonds – providing more control than workplace retirement plans!
You have several IRA options available to you. Traditional or Roth IRAs, SEP/SIMPLE IRAs for self-employed workers or small business owners and SIMPLE/SEP IRAs with higher contribution limits than regular IRAs may be suitable.
To be eligible to contribute to an IRA, both you and your spouse (if applicable) must receive taxable compensation in the form of wages, salaries, tips, commissions bonuses or net profit from self-employment. A loan from an employer can also help fund an IRA account.
Taxes on IRA Withdrawals
Income taxes payable on IRA withdrawals depend on several factors, including distribution type, age and whether or not your account is traditional or Roth. According to IRS requirements, all taxable distributions from both types of IRA accounts (traditional and Roth) should be reported on your tax return.
If you withdraw funds from an IRA before age 59 1/2, they’ll generally be taxed at ordinary income tax rates and incur a 10 percent penalty fee in an effort to deter you from using them for non-retirement-related expenditure.
IRS rules permit you to bypass this 10% penalty when withdrawing funds from an IRA for medical expenses or unemployment compensation payments that remain unreimbursed, tuition, fees, books and equipment needed for enrollment at an approved higher education institution, military reservists called up for active duty for at least 179 days and certain disabled individuals may take penalty-free distributions from their IRAs.
Required Minimum Distributions (RMDs)
IRS law mandates that upon reaching age 72 (or later for those born after 2024), individuals begin withdrawing minimum amounts annually from their IRA and employer-sponsored retirement accounts such as 401(k). This process is known as RMDs or Required Minimum Distributions.
RMDs are calculated based on your account balance and life expectancy, which decreases each year. Bankrate provides an RMD calculator which can assist in calculating annual withdrawals.
There are various strategies you can employ to reduce the tax bill associated with RMDs. One such technique is taking your RMD as a qualified charitable distribution (QCD). Doing this allows you to forego income taxes on its receipt.
As one way of lowering RMDs, consider converting some tax-deferred balances to Roth accounts and paying taxes on them – this will lower future withdrawal amounts as you’re withdrawing from smaller account balances. You could also consider investing in a Qualified Longevity Annuity Contract, known as QLAC, which guarantees payments throughout your life.
Rollovers
Rollovers allow you to move money from tax-deferred accounts, like traditional or SEP IRAs, into another tax-deferred one (such as Roth IRAs). Each year only one such “rollover” may take place, and can help avoid tax distributions as long as funds are transferred back within 60 days after receiving them from employer plans or custodians.
Indirect rollovers tend to be faster than transfers, but their 60-day limit leaves little wiggle room for error. With indirect rollovers, your former employer’s retirement plan or IRA custodian must withhold 20% for taxes before you can complete the rollover – adding an extra step and potential headache if you fail to follow rules correctly. Alternatively, direct transfers allow funds to move directly between accounts without withholdings or withholdings required from either account holder – saving both time and hassle in the process!
Categorised in: Blog