The tax laws regarding withdrawals from individual retirement accounts (IRAs) are complex. To avoid unnecessary penalties and to ensure you withdraw the funds efficiently, let's review the basics:
Before Age 59 1/2
In addition to any income taxes that may be due, withdrawals before the age of 59 1/2 are subject to a 10% federal income tax penalty. In certain circumstances, however, the 10% penalty will not be assessed:
- Distributions are made to beneficiaries after the IRA owner's death.
- Distributions are made to the IRA owner due to the owner's disability.
- Amounts distributed equal medical expenses paid in excess of 7.5% of adjusted gross income.*
- Distributions are made to certain unemployed IRA owners to pay health insurance premiums.*
- Distributions are made for up to the $10,000 lifetime limit for qualifying first-time homebuyer expenses.
- Distributions are made to pay qualified higher-education expenses for you, your spouse, your children, or your grandchildren.*
- Distributions are made as a series of annual withdrawals in substantially equal amounts over the owner's life expectancy or the joint life expectancy of the owner and beneficiary.*
* While distributions are exempt from the 10% federal tax penalty, these types of Roth IRA withdrawals are subject to ordinary income taxes on any earnings. The other Roth IRA withdrawals are penalty free and federal income tax free.
Between Ages 59 1/2 and 70 1/2
Between these ages, you can withdraw as much or as little as you like from traditional or Roth IRAs. Both contributions and earnings withdrawn from a traditional deductible IRA and earnings from a nondeductible IRA will be subject to ordinary income taxes. As long as the first contribution was made at least five years ago, Roth IRA distributions will not be subject to federal income taxes. Generally, you should postpone withdrawals as long as possible to continue tax-advantaged growth. However, in years when income is low, you may want to take distributions from a traditional IRA to take advantage of lower income tax rates. You may also want to convert all or part of a traditional IRA to a Roth IRA during low income years. While you will have to pay income taxes on the conversion, future earnings will accumulate tax free as long as you make qualified distributions.
After Age 70 1/2
You are not required to take distributions from a Roth IRA after age 70 1/2. You must, however, take required minimum distributions (RMDs) from your traditional IRAs every year or you will be assessed a 50% federal income tax penalty on amounts that should have been withdrawn. You can always take more out than the RMD. Your RMD is calculated by taking the account balance as of the preceding year divided by the life expectancy factor from a uniform table. The table is based on joint life expectancies and assumes your beneficiary is 10 years younger than you. If your spouse is your sole beneficiary and is more than 10 years younger, you can use either the uniform table or a table based on the actual joint life expectancy of you and your spouse.
Your first RMD must be made by the required beginning date (RBD), which is April 1 of the year after you turn 70 1/2. However, if you take the distribution in the following year, you will then take both your first and second distribution in the same year. Evaluate your tax situation before doing that. Two distributions may increase your income so you are in a higher tax bracket, lose tax deductions or credits, or Social Security benefits become taxable. In those situations, you may be better off taking your first RMD in the year you turn 70 1/2.
Heirs must generally start taking distributions by December 31 of the year after your death. Distributions by heirs are based on who your beneficiary is and whether you died before or after the RBD:
- If the account has a designated beneficiary, which includes individuals and certain trusts, the account balance is paid out over the beneficiary's life expectancy, based on a single life expectancy table. This calculation is used whether you die before or after your RBD. If the designated beneficiary is older than you, he/she can use your remaining life expectancy.
- A spouse can treat an inherited IRA as his/her own, but the surviving spouse has to be the sole beneficiary. However, if a spouse and other beneficiaries inherit an IRA, the account can be split so the spouse solely owns his/her share.
- If the account does not have a designated beneficiary, which includes your estate, charitable organizations, and certain trusts, and you die after your RBD, the balance is paid out over your remaining life expectancy. If you die before your RBD, then the balance is paid out within five years of your death.
The decisions you make regarding IRA withdrawals have important consequences for your retirement and for your heirs.