Individual retirement accounts, better known as IRAs, are investment vehicles that offer tax advantages and can help you save for retirement. However, there are many things to learn about them.
IRAs come with tax implications, which means your retirement savings will be taxed depending on the type of account you open. Additionally, as an account holder, you’ll be required to start taking distributions at a specific age and comply with other withdrawal rules. Otherwise, you could face penalties.
However, some strategies can help you avoid such penalties and minimize taxes on IRA withdrawals.
Want to understand IRA withdrawal rules and how you could be penalized? Interested in learning strategies to reduce tax burdens? This guide contains all the information you need. Read on!
Understanding Individual Retirement Accounts (IRAs)
As mentioned, an IRA is an individual retirement account. It’s similar to a savings account but offers certain tax advantages, as contributions can be tax-deductible, or your money can grow tax-free, depending on the option you choose. You can read more in our introduction to individual retirement accounts article.
Purpose of an IRA
IRAs have been designed to help people with earned income save toward retirement. Actually, these accounts offer one of the most effective ways to invest for the future.
Types of IRAs: Traditional and Roth
- Traditional IRA: With this account, you can make tax-deductible contributions, which means you won’t have to pay taxes on your retirement savings until you take a distribution. Withdrawals are subject to income taxes.
- Roth IRA: These accounts allow you to make contributions with after-tax dollars, so they aren’t tax deductible. However, qualified withdrawals are tax and penalty-free.
Contribution and Deduction Limits
If you’re an IRA holder, you can contribute to your account each year up to the maximum amount set by the Internal Revenue Service (IRS). In 2024, the limit is $7,000. Individuals aged 50 and over can make catch-up contributions of $8,000.
You may also be able to claim a deduction on your tax return for the amount of money you contribute to your individual retirement account, but there are also limits. These rules vary based on the type of IRA you have.
Roth IRA contributions don’t qualify for deductions. However, you can claim a deduction on your federal income tax return for the money you contribute to a traditional account.
These are the limits for traditional IRAs:
- If you or your spouse (if you’re married) are covered by a retirement plan at work and earn an income that exceeds certain levels, your deduction will be limited.
- If you or your spouse (if you’re married) aren’t covered by a retirement plan at work, you can claim a full deduction on your tax return for your traditional IRA contribution.
Investment Options within an IRA
IRAs are flexible in terms of investments, which means many options are permissible inside these accounts. These are some of the most common:
- Real estate
- Mutual funds
- Unit investment trusts (UITs)
- Exchange-traded funds (ETFs)
- Real estate investment trusts (REITs)
Some investments cannot be held in an IRA, including the following:
- Any type of life insurance contracts
- Any type of derivative trade that has unlimited or undefined risk
- Antiques and collectibles, such as metals, gems, coins, and artworks
- Real estate for personal use
IRA Withdrawal Basics
The IRS has set several rules on traditional and Roth IRA withdrawals, but they vary based on the type of account you have.
Age Considerations for IRA Withdrawals
If you have a traditional IRA, you should wait until you turn at least 59.5 years old to withdraw money from your retirement account. Otherwise, those withdrawals will be subject to income taxes and penalties unless you qualify for an exception.
Roth IRA withdrawal rules are slightly different. Distributions taken from these accounts are tax and penalty-free. However, withdrawals must be qualified.
Early Withdrawals: Consequences and Exceptions
Withdrawing money from traditional IRAs before age 59.5 may result in a 10% penalty and regular income tax on the amount you take as a distribution unless you qualify for an exception.
Although qualified withdrawals from Roth IRAs are tax and penalty-free, even if made before age 59.5, you may be subject to penalties and taxes if the amount you take as a distribution is greater than what you have contributed in total.
Normal Withdrawals: Post 59½ Age Rule
Traditional and Roth IRA withdrawal rules become less strict when you reach age 59.5. It isn’t mandatory, but you can take distributions from both accounts without penalties.
However, withdrawals will be taxed differently. If you take a distribution from a Roth IRA, it won’t be taxed as long as you comply with the five-year rule.
With a traditional IRA, you’ll be required to pay taxes on withdrawals of contributions that qualify for a deduction on your tax return and on earnings.
Late Withdrawals: Required Minimum Distributions
Roth IRA withdrawals aren’t mandatory at any age. However, you should take the required minimum distributions (RMDs) from your traditional IRA as soon as you turn 72 (or 73 if your birthday is after December 31).
According to IRS rules, you must take your first RMD by April 1 of the year following the year you reach that age. These distributions are based on the account’s prior year-end balance and your life expectation.
Tax Implications of IRA Withdrawals
Besides exploring the distribution rules, it’s important to understand the tax implications of IRA withdrawals.
Taxable and Non-taxable Withdrawals
If your contributions to a traditional IRA are deductible, earnings will be taxed as ordinary income. This applies to dividends or capital gains.
Non-deductible contributions, which are available in some traditional IRAs, will create a tax basis in your account. As a result, each withdrawal will include an amount of basis that will be tax-free.
Roth IRA withdrawals are non-taxable as long as you meet the five-year holding requirement. Some people can take tax-free distributions from accounts that have been open for over five years if they’re under age 59.5 as long as they use the money to pay a first-time home purchase, become disabled, or pass away.
However, if you take a distribution of earnings before the account is five years old and before you reach age 59.5, the amount will be subject to both taxes and penalties.
Non-qualified withdrawal penalties can be avoided if the money is used for specific purposes according to the exceptions set by the IRS, which may include qualified medical expenses or health insurance premiums, costs related to disasters, and more. However, they’ll always be taxed.
Federal and State Taxes on Withdrawals
Early withdrawals from IRAs, which are those made before age 59.5, will be treated as ordinary income according to your current federal and state income tax brackets, if applicable.
In 2024, there are seven federal tax brackets in the country. These are: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Your rate will be determined by two factors: your taxable income and your filing status.
Plus, distributions may be subject to a 10% additional tax penalty.
Penalty-free Withdrawals and Exceptions
If the unexpected happens and you need to withdraw money from your IRA before you turn 59.5, you can do so. As mentioned, this action may result in penalties. However, there are possible exceptions.
Understanding the 10% Early Withdrawal Penalty
More often than not, distributions you take from your IRA before age 59.5 will be considered “early,” so you’ll be required to pay a penalty of 10% of the amount you withdraw. Additionally, these amounts may be subject to federal and state taxes. This penalty usually applies to traditional IRAs.
Qualified withdrawals from Roth IRAs will be tax and penalty-free.
If you haven’t met the five-year requirement, which would make distributions non-qualified, withdrawals from conversion contributions may be subject to a 10% recapture penalty.
Specific Exceptions to Early Withdrawal Penalties
Do you want to know if you can make a withdrawal from your IRA before age 59.5? You can avoid penalties for early distributions that fail under certain exceptions, including the following:
- First-time home purchase
- Unreimbursed medical expenses
- Educational expenses
- Disability or death
- Birth or adoption expenses
- Health insurance premiums
- Periodic payments
- Qualified disaster
- Involuntary IRA distribution
- Emergency personal expenses
- Domestic abuse
- Reservist IRA distributions
Roth IRA Specifics
Roth IRAs are different from traditional IRAs, which means some factors make them unique in terms of contribution and withdrawal rules. Let’s go over the specifics of this type of account.
Roth IRA Contributions vs. Earnings
If you have a Roth IRA, withdrawal rules vary depending on whether you take a distribution from the contributions you made or from your earnings. Therefore, it’s important to understand what each means.
A Roth IRA contribution is the money you deposit into your account, while earnings are the profits that result from the growth of your investments.
Roth IRA Income and Contribution Limits
Here’s an effective way of understanding Roth contribution limits. Your eligibility to contribute to a Roth IRA will depend on your income level or Modified Adjusted Gross Income (MAGI).
These are the Roth IRA income limits the IRS has set for 2024:
- If you’re a single tax filer, your MAGI must be under $161,000.
- This cap is higher ($240,000) if you’re married and pay taxes jointly.
The IRS has also set rules on the maximum annual contribution you can make for your individual retirement accounts, including Roth IRAs. In 2024, these are:
- $7,000 if you haven’t reached age 50
- $8,000 if you’re over that age
The Five-Year Rule for Roth IRAs
This rule only applies to Roth IRAs and states that at least five years must pass since the start of the tax year of your first contribution before you can take tax and penalty-free distributions of earnings from your account.
Qualified and Non-Qualified Distributions from a Roth IRA
If you’re 59.5 years old, you can withdraw the contributions you made to your Roth IRA at any time. These distributions will always be tax and penalty-free because they’re considered “qualified.”
However, you may be required to pay taxes and penalties if you withdraw Roth IRA earnings before reaching age 59.5 and meeting the five-year rule, as these withdrawals will be treated as “non-qualified” distributions.
Although non-qualified distributions are always taxed, you could avoid penalties if withdrawals are eligible for exceptions.
Also, distributions aren’t subject to penalties if they’re made as follows:
- In substantially equal periodic payments
- In connection with a qualified disaster where you live
- Due to an IRS levy
Roth IRA Conversion: Process and Tax Implications
Many people decide to convert all or part of their traditional individual retirement account to a Roth IRA to avoid paying taxes on withdrawals made during their golden years.
This process is simple. According to the IRS, you can do a Roth IRA conversion through a rollover, a trustee-to-trustee transfer, or a same-trustee transfer. However, it comes with tax implications.
If you convert a traditional IRA to a Roth IRA, you’ll have to pay taxes on any money that would have been subject to taxes upon withdrawal, including tax-deductible contributions and tax-deferred earnings. However, you’ll be able to take tax and penalty-free distributions in five years.
Plus, these funds will be treated as income in the year this conversion is made.
Strategies to Minimize Tax on IRA Withdrawals
Do you want to know how you can minimize taxes on IRA withdrawals? Let’s explore some of the options available:
Using a Roth IRA or Roth 401(k)
Opening a Roth IRA or converting your existing account to one could help you avoid taxes on withdrawals, as your money grows tax-free because you pay taxes upfront when you make contributions.
The Backdoor Roth IRA Strategy
A backdoor Roth IRA is a strategy that involves converting a traditional IRA to a Roth IRA. It’s often used by high-income earners who want to open these accounts but don’t meet the eligibility criteria set by the IRS.
With this strategy, high earners can make contributions to traditional IRAs after paying taxes and then convert that money into a Roth IRA.
Substantially Equal Periodic Payments Rule
According to the IRS rules, the additional 10% tax penalty doesn’t apply to distributions that are made in substantially equal periodic payments over the life expectancy of the taxpayer or their designated beneficiary.
Tax-efficient Withdrawal Strategies
Besides the two methods described above, you can consider the following strategies to increase tax efficiency when making withdrawals from your IRAs:
- Start taking distributions as soon as you reach age 59.5 or before they’re mandatory
- Make a qualified charitable distribution to satisfy your RMDs
- Keep investments with potential capital gains that get preferential tax treatment out of your IRAs
Unique IRA Withdrawal Scenarios
In some scenarios, early IRA withdrawals aren’t subject to penalties, including the following:
Inherited IRA: Rules and Distribution Options
If you inherit an IRA, which means you’re the beneficiary of that account, the distributions you take won’t always be subject to the 10% early withdrawal penalty. However, they’ll be taxed.
This rule may vary depending on how beneficiaries distribute the account’s funds. Overall, these are the options they can consider when they inherit an IRA:
- “Disclaim” the inherited IRA
- Transfer the funds into their own account (only available for the surviving spouse, but they may have to pay the early withdrawal penalty)
- Take a lump-sum distribution
- Open a stretch IRA (only available if they’re designated beneficiaries, but different RMD rules apply)
- Distribute the assets within 10 years (available to designated beneficiaries but may be subject to penalties if the account isn’t emptied within 10 years)
- Distribute assets received through a will or estate (available to individuals not listed as designated beneficiaries with RMD rules based on the original account owner’s age)
If you wish to understand inherited IRA distributions in more detail, read our comprehensive article, which will provide all the necessary information.
Using IRA for Adoption or Higher Education
The birth or legal adoption of a child is also considered an exception. If funds withdrawn from IRAs are used for these purposes, they won’t be subject to a 10% early distribution penalty.
IRAs can also be sources of funding for higher education expenses for the account holder, their spouse, or their child under certain circumstances.
If these expenses are qualified and used for fees, tuition, supplies, books, or equipment required for enrollment, there will be no 10% early withdrawal penalty.
IRA Distributions for Medical Expenses and Health Insurance
You can take early penalty-free distributions from your IRA to cover out-of-pocket medical expenses that aren’t covered by insurance or if you don’t have a policy as long as they’re paid during the same year you make the withdrawal.
IRA and IRS Levy: What You Should Know
The IRS can draw on an individual’s IRA to pay their tax bill if they have unpaid federal taxes. The 10% tax penalty doesn’t apply to withdrawals if this entity levies the money directly. However, the funds cannot be taken as a distribution to pay taxes and avoid the levy.
Spousal IRA Withdrawal Rules
A spousal IRA is a typical individual retirement account used by a married person that allows their non-working spouse to make contributions if they both file a joint tax return.
Understanding Spousal IRAs
If you open a spousal IRA, that account won’t be co-owned. Instead, you and your spouse will each have an IRA under your own names.
Contributions limits for spousal IRAs are the same as those for any other individual retirement account. Each spouse can make a contribution as long as it doesn’t exceed the maximum amount.
Withdrawal Rules for Spousal IRAs
Both spouses can enjoy distributions from their spousal IRAs during retirement. However, if the account holder dies, the designated beneficiary who inherited the plan must comply with RMD rules.
When the account holder dies before the required date to start taking RMDs and the IRA is inherited by a spousal beneficiary, they have these options:
- Keep the IRA as an inherited account, which means they have to comply with the five-year rule (empty the account within five years after the holder’s death and avoid making withdrawals during this period) and take RMDs based on their life expectancy
- Rollover the account into their own IRA
The five-year rule doesn’t apply if the account holder dies after the required beginning date and the IRA is inherited by a spousal beneficiary.
If the account holder’s death occurred in 2020 or later, these rules are slightly different. Spousal beneficiaries may be required to comply with a 10-year rule, which means they must empty the account within 10 years and file the required Notice 2022 -53. Plus, they may have to delay distributions until the holder would have turned 72 if the death occurred before the required beginning date and they decide to keep it as an inherited account.
Rollover Options for Spousal IRAs
The surviving spouse can name themselves as the owner of the IRA, making the account an inherited one if they already treat it as their own.
When inherited assets are moved via a direct transfer, surviving spouses must follow the same IRA rules they would under normal circumstances.
If they have their own IRA and are named beneficiaries, the surviving spouse can also move their funds to their new account through a 60-day rollover. This is possible if the account holder dies on or after the required beginning date.
However, rollovers are only allowed for spousal IRAs if the year-of-death RMDs are taken.
IRA Rollover Rules and Considerations
You can roll over IRA funds by moving them to a new account or retirement plan within 60 days. Failure to deposit the money into the new account within that period may result in income taxes and penalties.
However, there are many other things to learn about this process.
Understanding IRA Rollovers
IRA rollovers enable you to move your distributions from one retirement plan to another account, allowing the money saved for retirement to continue growing tax-deferred.
You’re asking what is a rollover IRA? We have a detailed article where we shed the light on all rollover IRA aspects and facts.
Direct vs. Indirect Rollovers
There are two types of IRA rollovers:
- Direct rollover: The funds are moved directly between accounts without you touching the money.
- Indirect rollover: The funds are given to you, so you’re responsible for depositing them into the new account.
Tax Implications of Rollovers
Generally, IRA holders don’t pay taxes on the distribution that is rolled over until it’s withdrawn from the new account.
However, funds that aren’t rolled over may be considered taxable. You may be required to pay additional taxes unless you’re eligible for any exception to the 10% early withdrawal penalty.
The IRS says that individuals cannot make more than one rollover for the same IRA or from the IRA the distribution was rolled over within one year.
Frequently Asked Questions
What are the penalties for withdrawing from an IRA before age 59 ½?
Withdrawing money from an IRA before age 59.5 could result in a penalty of 10% of the amount you took as distribution and federal or state income taxes, if applicable.
What are the exceptions to the early withdrawal penalty?
Early withdrawals from traditional and Roth IRAs may be allowed if they’re used for the following:
- First-home purchase
- Certain emergency expenses
- Qualified education expenses
- Qualified birth or adoption expenses
- Reimbursed medical expenses
- Health insurance premiums
- Death or disability
- Domestic abuse
Distributions made in connection with a federally qualified disaster, due to an IRS levy, or in periodic payments aren’t subject to penalties.
How does a Roth IRA differ from a traditional IRA in terms of withdrawal rules?
Traditional IRA withdrawals will be subject to taxes. That doesn’t happen with a Roth IRA since you can take distributions without paying taxes.
There are no RMDs for Roth IRAs. Early withdrawal rules are also different, as distributions from these accounts must be taken after a five-year holding period.
What strategies can I use to minimize tax on my IRA withdrawals?
Different strategies can help you minimize taxes on IRA withdrawals, including the following:
- Convert your IRA to a Roth IRA
- Take RMDs before they’re mandatory
- Contribute to a charity if you’re 70.5 years old or over
Can I use my IRA money for purposes like education or home purchase without incurring penalties?
Yes, you can. You could avoid penalties if early withdrawals are used to cover some expenses related to education and the purchase of your first home. However, it’s important to know that the IRS only accepts some exceptions.
IRAs have been designed to help people save for retirement. However, it’s important to understand the rules that the IRS has set for these accounts, especially when it comes to withdrawals.
Individual retirement accounts offer tax benefits, but that doesn’t mean you won’t have to pay taxes during your golden years. This may vary depending on the account you choose.
However, if you take the time to learn about IRA withdrawal rules and requirements, you can minimize tax burdens when taking distributions to optimize your retirement savings.