Avoiding taxes on IRA withdrawals is difficult if you have a traditional IRA. If you have a Roth IRA, it’s not a problem, as these withdrawals aren’t subject to tax. As far as federal taxes, IRA distribution tax is at the ordinary income level.
TL;DR (Too Long; Didn't Read)
The best way to avoid paying taxes on an IRA withdrawal is by contributing to a Roth IRA account if you meet income eligibility limits. Since Roth IRAs are funded with post-tax dollars, withdrawals aren't subject to tax, and there are other advantages, too.
IRA and 401(k) Withdrawal Tax
If you have a traditional IRA, a Simplified Employee Pension or SEP IRA, a Savings Incentives Match for Employees of Small Employers or SIMPLE IRA or a Salary Reduction Simplified Employee Pension Plan or SARSEP IRA, you must pay taxes on withdrawals. You must also take Required Minimum Distributions or RMDs from your IRA by the time you turn 70 ½. Failure to do so results in a steep penalty from the Internal Revenue Service, a whopping 50 percent on the amount that should have been withdrawn but was not.
You can start making traditional IRA withdrawals without penalty once you turn 59 ½. If you make withdrawals before then, except in limited circumstances, expect to pay a 10-percent penalty on the amount withdrawn as well as tax. If you also have an employer-sponsored retirement plan at work, your 401(k) penalty calculator is the same as for an early IRA withdrawal.
IRA Early Withdrawal Penalty Exceptions
Under some circumstances, the IRS will permit you to make an early withdrawal from your traditional IRA without paying the steep penalty on the amount. You can take out the funds for qualified educational purposes for yourself, your spouse, children or grandchildren. To qualify, the school must meet federal student aid program requirements as approved by the IRS. That does include the majority of institutions of higher learning in this country, but if you have doubts, make sure to check the school’s accreditation first. You can use the money from your traditional IRA to pay for tuition, fees, books and other necessary equipment, but the student must have a minimum of half-time enrollment for you to pay room and board from these funds.
If you are a first-time home buyer, you may withdraw up to $10,000 from your IRA to pay for your new home. If your spouse also has a traditional IRA account, that’s $20,000 that can go toward a home purchase. Even the definition of first-time is somewhat flexible. If you and your spouse didn’t own a primary residence for the previous two years, the IRS considers you a first-time homebuyer for IRA withdrawal purposes. You can also use your IRA funds to put a down payment on a house for a first-time homebuyer if that person is your parent, child or grandchild.
The IRS also doesn’t impose a tax on hardship withdrawals. These include unreimbursed medical expenses, medical insurance premiums if you are out of work or if you suffer total or permanent disability.
Roth IRA Tax-Free Withdrawals
If you contribute to a Roth IRA, your withdrawals are tax-free as long as you are over age 59 ½ and your account has been in existence for at least five years. That’s because, unlike traditional IRAs, Roth IRAs are funded with post-tax dollars. You can’t deduct your Roth IRA contributions, but unlike traditional IRAs, there are no RMDs with a Roth IRA. If you desire, you don’t have to ever make a withdrawal from your Roth account and can allow the funds to continue growing tax-free for your heirs. If you intend to work past age 70 ½, you can still contribute to your Roth IRA, which is not the case with a traditional IRA. If you do need to take money out before the age of 59 ½, you can do so tax-free as long as you aren’t withdrawing investment gains. You must tell the trustee in charge of your Roth account that only your contributions are to be withdrawn in this scenario.
However, while anyone earning wages can open a traditional IRA, Roth IRA contributions have an income limitation. The amount of these limitations change annually. As with a traditional IRA, you may contribute up to $5,500 annually if you make at least that much in income, and $6,500 if you're over age 50. For 2018, a married couple filing jointly can both make Roth contributions if their adjusted gross income is less than $189,000. If their AGI is below $199,000, they can contribute a reduced amount, but over $199,000 they are ineligible to contribute to a Roth IRA. Single filers can make a full Roth contribution if their AGI is less than $120,000, and can make a partial contribution if their AGI is less than $135,000. If their income is $135,000 or more, they cannot contribute.
Converting to a Roth IRA
So if you have a traditional IRA and not a Roth, are you simply out of luck when it comes to avoiding federal taxes? Not necessarily. You can convert a traditional IRA to a Roth IRA for long-term tax savings, but there are initial tax consequences. When you create a conversion, the amount withdrawn is considered a taxable distribution from your traditional IRA. That means you’ll get hit with a bigger federal tax bill for the year, and possibly a larger state tax bill. On the plus side, the Tax Cuts and Jobs Act signed into law by President Donald J. Trump on December 22, 2017, lowered federal income tax rates, so the tax bite for conversion isn’t as harsh as in previous years. These rates will stay in effect until 2025.
The TCJA did make one change that can adversely affect those making a traditional to Roth IRA conversion, and that is the ending of re-conversion. Before the TCJA, if you decided that converting to a Roth wasn’t a good idea, you had until October 15 of the year after the conversion to reverse it, which meant you didn’t pay the conversion tax. Now, you can’t reverse a conversion. Keep in mind that converting a traditional IRA into a Roth IRA makes the most sense for those who believe their retirement income will remain about the same level, or higher, than their income during their working lives.
States That Don’t Tax Withdrawals
You can avoid paying state taxes on your traditional IRA withdrawals if you live in one of the seven states that don’t impose income taxes. Currently, that’s Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. However, other states exclude at least some IRA withdrawals from tax, and a few are quite generous. For example, Georgia spares residents over age 65 from taxes on retirement income up to $65,000, and you can exclude up to $35,000 from age 62 to 64. Illinois, Mississippi and Pennsylvania are even better, as none of these states tax IRA withdrawals. Kentucky excludes up to $31,110 of all retirement income from taxation, including IRAs, and does not tax Social Security benefits. If you were born before 1946, Michigan excludes up to $49,861 in retirement income from tax. Other states allow you to exclude a lower amount of IRA income from tax.
- Retirement Living: Taxes by State
- Investopedia:How Much Are Taxes on an IRA Withdrawal?
- Bankrate: When You Can Tap Your IRA and Avoid a Tax Penalty
- Forbes: Senior Specials: 14 States With Retirement Income Tax Breaks
- IRS: Amount of Roth IRA Contributions That You Can Make for 2018
- Marketwatch: How the New Tax Law Creates a Perfect Storm for Roth IRA Conversions
- IRS: Retirement Topics - Exceptions to Tax on Early Distributions
A graduate of New York University, Jane Meggitt's work has appeared in dozens of publications, including PocketSense, Zack's, Financial Advisor, nj.com, LegalZoom and The Nest.