Because contributions are tax-deductible and earnings grow tax-deferred, traditional IRAs are popular for saving for retirement. However, because withdrawals from a traditional IRA are subject to taxes and, in some cases, penalties, it is important to be aware of the requirements related to taking money from an IRA.
While contributions to a traditional IRA are tax-deductible, you must pay income taxes at your current rate on the full amount of any withdrawal. You can make withdrawals from a traditional IRA at any time, but any made before age 59 1/2 is subject to a 10 percent early-distribution penalty, in addition to any income tax owed. You may withdraw IRA contributions tax-free if you make the withdrawal before the due date for filing your tax return for the year during which the contributions were made.
If you do need to withdraw money from an IRA, the IRS will waive the 10 percent early distribution penalty in several circumstances. If the money is used to pay unreimbursed medical expenses above 7.5 percent of your adjusted gross income (AGI) or to pay for medical insurance if you’ve lost your job, the penalty will be waived. You may also withdraw money without penalty if you are disabled or to pay for certain higher education expenses like tuition, books and supplies. You can withdraw up to $10,000 penalty-free to purchase a first home for yourself or qualifying relatives. The IRS has specific requirements for waiving the penalty in these and other cases, so it’s important to make sure you meet them before taking a distribution.
Required Minimum Distribution
You must begin taking required minimum distributions when you reach age 70 1/2. The first RMD must be taken by April 1 of the year after you turn 70 1/2. For example, if you turned 70 1/2 in 2012, you must take your 2012 RMD by April 1, 2013, your second RMD by Dec. 31, 2013, and all subsequent RMDs by Dec. 31 of each year thereafter. RMDs not taken by the due date are subject to a 50 percent excess accumulation penalty. The amount of the RMD depends on age and the amount in the IRA.
Traditional IRA distributions are generally taxed as ordinary income. If you expect to be in a higher tax bracket in retirement than you are now, the effect of the current tax break on contributions may be outweighed by withdrawals being taxed at a higher rate. Also, if you plan on leaving funds in your IRA to children or other heirs when you die, any withdrawals they take will be taxed at their current rate, which may be higher if they are in their peak earning years when they take money. In cases like these, consult a financial adviser to see if another plan, such as a Roth IRA, may be a better option for you.
Ben Bontekoe is a published writer with an extensive background in personal finance, banking, career counseling and education. A graduate of Calvin College, he has worked for major financial institutions including Bank of America and Citibank.