There are no smoke and mirrors solutions to pull the wool over Uncle Sam's eyes. You can, however, avoid prison time while skirting, or at least reducing, taxes on your IRA withdrawals via perfectly legal methods. When and why you need your money, how you access it, the type of account you own and your age are key factors that dictate the tax ramifications of your IRA distributions.
Fund a Roth IRA. While the money you contribute is not tax-deductible, the IRS allows you withdraw Roth IRA proceeds completely tax-free once you turn age 59 1/2, so long as you have held the account for a minimum of five tax years, according to IRS Publication 590.
Access Roth contributions first if you take them out prior to age 59 1/2 or violate the five-year requirement. Regardless of when you remove them, contributions always come out tax-free, but the IRS taxes earnings on early, non-qualified withdrawals. Your IRA custodian -- the firm you opened your account with or transferred it to you -- should automatically order your withdrawals, distributing contributions before earnings.
Use an exemption. With a Roth IRA, you can remove money, including earnings, for several reasons prior to age 59-1/2, such as using up to $10,000 to buy, build or rebuild your first home. While you can also use the cash to fund higher education expenses, this option only lets you escape the 10 percent tax penalty on early withdrawals, not taxes on Roth earnings. These exceptions apply to costs you incur or cover for your spouse, children or grandchildren. While the same exceptions apply to traditional IRAs vis-a-vis the 10 percent penalty, the IRS charges regular income tax on all traditional IRA withdrawals, regardless of age or purpose.
Hold off on taking traditional IRA withdrawals until you find yourself in a lower tax bracket. With a Roth, this is less of an issue, particularly once you reach 59 1/2 and satisfy the five-year rule, because at that stage, the IRS does not tax Roth withdrawals. With a traditional IRA, however, you pay tax on withdrawals. If you are age 60 and working, you'll likely pay more tax than if you wait until you retire from work, presumably fall into a lower tax bracket and start taking distributions.
Wait as long as you can to access money. With a Roth IRA, the IRS allows you to keep the money in your account for as long as you desire. You can die without touching a Roth IRA nest egg. With a traditional IRA, the IRS lets you hoard until the year after you turn age 70 1/2. At that juncture, you'll need to begin taking an annual required minimum distribution or face a 50 percent excise tax on the amount you were supposed to, but failed to take.
- Get an up-front tax benefit by funding a traditional IRA. As noted, the IRS always taxes traditional IRA distributions, however, a key benefit of a traditional IRA is that you can deduct your contributions, up to an annual limit. Your traditional IRA investments reduce your taxable income, which should lower your total tax due and, subsequently, your tax bill.
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