Taxes on IRA Withdrawals
Traditional IRAs are an effective way of saving for retirement, but withdrawals must be taxed by the IRS.
Your tax burden depends on various factors, including age, the nature and purpose of withdrawals made from retirement plans, whether or not an RMD occurs, as well as any applicable minimum distribution (RMD) obligations that need to be fulfilled. Sometimes your liability could even be zero!
Taxes on IRA withdrawals
IRA funds withdrawn prior to age 59 1/2 are subject to regular income tax and could incur an early withdrawal penalty of 10% depending on your individual circumstances. Rollover of money into another IRA or conversion to Roth IRA have no immediate tax implications and custodians of your IRA will withhold 10% for federal income taxes unless waived or elected a higher withholding amount is chosen from you.
Your IRA allows for penalty-free withdrawals to cover certain expenses, such as education fees and uninsured medical costs that exceed 7.5% of adjusted gross income and first-time home purchases. However, traditional and SEP IRAs that have earned unqualified distribution income (UBTI) require taxes be withheld from withdrawals made after turning 70 1/2; IRS tables provide easy ways of calculating annual RMDs.
Early withdrawal penalty
Traditional IRA savers who withdraw funds prior to reaching age 59 1/2 typically face a 10% early withdrawal penalty in addition to income taxes; this penalty is intended as a deterrent, though there may be exceptions.
One notable exemption to the penalty is for first-time home buyers using their IRA funds to buy, build or rebuild a house using qualified acquisition costs only – these being both purchase price as well as “usual and reasonable settlement, financing and closing costs”.
Self-employed or small business owners who pay health insurance premiums without incurring penalties can withdraw IRA funds without penalty to cover premiums for themselves and eligible family members, this includes SIMPLE or SEP-IRA plans they established themselves, as well as those held by owners who haven’t met their annual minimum distribution requirement yet.
Rollovers
The rules surrounding IRA withdrawals depend on the type of account. Withdrawals from Traditional IRAs may be subject to income tax; while those from Roth IRAs don’t incur that expense. Self-employed individuals can save even more with SEP and SIMPLE IRAs that offer rollover capabilities into other Traditional and/or Roth accounts.
Any eligible IRA distribution you receive will have 20% withheld for federal taxes by default, unless you waive or opt to have more withheld. Use these values reported on Form 1099-R to file your personal tax return.
An IRA rollover can only occur once per year, so it is crucial that any move of your retirement funds be managed carefully and successfully. A missed 60-day deadline when purchasing a motorcycle or using its proceeds towards home purchase could lead to hefty taxes; for this reason it would be wiser to consult a certified financial planner or CPA who will offer tailored guidance and help.
Exceptions
Though you typically incur a 10% penalty when withdrawing money from an IRA before turning 59.5 years old, there are exceptions to this rule. For example, if your out-of-pocket medical expenses exceed 7.5% of adjusted gross income and require funds withdrawal without incurring penalty; similarly if using your IRA to purchase your first home the penalty doesn’t apply.
These exceptions may not be as prevalent, but it’s essential that they’re kept in mind if you plan on tapping your retirement savings early. Furthermore, it would be prudent to consult a trusted financial advisor in order to assess what taxes may apply based on early withdrawal.
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