One of the main advantages of investing through an IRA is that, as long as your money stays in the account, taxes on investment gains are delayed. But when it comes time to start making withdrawals, taxes can start accruing fast.
Depending on what type of account you have and when you make the withdrawals, your tax bill can vary significantly. Here are some things to keep in mind so you can minimize taxes on your IRA withdrawals.
Account Type Matters: Traditional vs. Roth IRA
There are two main types of IRAs – Traditional and Roth – both have very different tax rules, and Roth accounts are best for minimizing taxes upon withdrawal. The Traditional IRA gives you a tax deduction on the front end of your IRA, when you make a contribution. But the Roth IRA, instead of giving you an immediate tax benefit for contributions, will yield tax savings at the time of withdrawal.
Timing Matters Too: Early Withdrawals and Exemptions
Since IRAs are intended to be a retirement account, taking money out before you stop working or hit a certain age will usually lead to taxes. But again it depends on what type of account you have.
With a self-directed IRA, money taken out before you turn 59 ½ is considered an early withdrawal by the IRS, and thus subject to taxes.
However, if you have a Roth IRA you are allowed to take out contributions – but not investment gains – without owing any taxes. For example, if you added $10,000 to your Roth, you can take out $10,000 tax-free. If you withdraw any money that you have earned on investments from that same Roth IRA, you will owe income taxes on amount withdrawn. Depending on how old you are when you take the money out, you might also owe an additional 10 percent early withdrawal penalty.
Similarly, withdrawals made at any time on a Traditional IRA are subject to income tax (and the early withdrawal penalty if you are younger than 59 ½).
But there are ways to avoid the early withdrawal penalty and taxes, depending on your circumstances. If you qualify for any of the categories below, you may be able to minimize taxes on your IRA withdrawals.
1. Disability – If you become disabled and can’t work, you can take money out of your IRA without penalty.
2. First home purchase – You can take out up to $10,000 from you IRA penalty-free to buy or build your first home.
3. Medical expenses – If you have medical bills that add up to more than 10 percent of your adjusted gross income for the year, you can take money out of your IRA to pay bills that are over this limit.
4. Health insurance – If you are unemployed, you can make withdrawals to buy health insurance.
5. Tax lien – If you are behind on your income taxes, the IRS could place a lien against your IRA for payment. You could then take money out penalty-free to pay your back taxes.
6. Higher education – If you or a family member goes to a qualified college or university, you can take money out of your IRA to pay for school expenses like tuition, books, and room and board.
7. Called up to active duty for the military reserves– If you are a member of the military reserves and called up for a period of active duty that lasts at least 180 days, you can make withdrawals while on active duty.
8. Equal periodic payments – You can divide up your IRA into equal periodic payments based on your life expectancy, as calculated by the IRS. You’d need to receive these periodic payments for at least 5 years or until you turn 59 ½, whichever comes first, to avoid the penalty.
9. Death – If you die before retiring, the person who inherits your IRA can make withdrawals without owing the penalty.
Minimizing Taxes After Retirement
Once you turn 59 ½, you can start making retirement withdrawals from your IRA without fear of the 10 percent penalty, regardless of whether you are still working or not. Withdrawals on Roth IRAs are completely tax-free. But any withdrawals on a Traditional IRA will be taxed as income, not the lower capital gains rate.
In order to avoid getting pushed into a higher tax bracket due to income gains from Traditional IRA withdrawals, you may want to balance out those withdrawals with other IRA accounts during retirement. For example, if you split your savings between a Roth and Traditional IRA, you may want to take money out of both accounts every year to avoid a hefty tax hit.
Another common strategy involves spending the money in your Roth IRA and regular brokerage account while keeping your savings in the Traditional IRA, since that money will continue to grow while deferring taxes. But there is a catch. When you turn 70 ½, you must start making the Required Minimum Distributions – IRS-mandated withdrawals calculated by your account balance and life expectancy – from your Traditional IRA. If you don’t make these required withdrawals annually, the IRS will charge you a penalty of 50 percent of your calculated RMD.
Some people view their IRA account as an inheritance for heirs. If that’s the case, keep in mind that an inherited IRA retains its tax status. Both a Traditional and Roth IRA can be inherited, and their withdrawals will be subject to the same tax rules as the original account owner.
You worked hard to build your retirement savings so make sure that money doesn’t just go to the IRS. Keep reading to learn more about IRA strategies and Required Minimum Distributions.