Taxes on IRA Withdrawals

Depending on whether your retirement account is a Roth IRA or a traditional IRA, the money you withdraw from your IRA may be subject to federal income tax as well as state and/or local taxes if you live in an area that taxes income. Additionally, you may face an IRS penalty if you take out the funds too soon or if the withdrawal does not meet the criteria for a qualified distribution.

Understanding the specific rules and regulations governing your IRA will help you make informed decisions about your retirement savings. Moreover, knowing the changes in tax laws and retirement regulations can empower you to optimize your retirement planning and maximize your savings.

Roth IRAs are retirement accounts funded with after-tax dollars. Your post-tax contributions mean you can withdraw your contributions from your Roth account at any age without paying more taxes on the money you put in.

However, you’ll still pay taxes on any investment earnings you withdraw or any other non-qualified distribution. You’ll also pay an extra 10% tax penalty on the non-qualified withdrawal.

A qualified distribution takes place at least five years after you first fund a Roth IRA account. You must also be at least 59 1/2 years of age, disabled or planning to use your money to buy a first home for yourself or a direct family member. Consult with a financial advisor before withdrawing money from your Roth IRA to confirm that you meet the qualifying criteria.

You make contributions to traditional IRAs with pre-tax dollars. Because the money that goes in has yet to be taxed, any withdrawals and minimum required distributions from traditional IRAs are taxed as ordinary income, regardless of your age or circumstances. The tax rate depends on your income level at the time you take your money out. Depending on where you live, you may also owe state or local taxes on that income.

Although some exceptions exist, you may face a 10% penalty if you withdraw money from your traditional IRA before reaching the age of 59 1/2 years. Disabled people of any age can withdraw money from an IRA with no penalties.

You can also withdraw money penalty-free to cover certain expenses, including higher education fees, unreimbursed medical expenses that are more than 7.5% of your adjusted gross income (AGI), medical insurance premiums if you’re unemployed for at least 12 weeks and first-time home purchases. To be safe, talk to your financial advisor before making any withdrawals.

In most cases, you’ll have to pay taxes on any IRA withdrawals you make before you reach the age of 59 1/2 years. Withdrawals from traditional, SEP and SARSEP IRAs are taxed at your ordinary income tax rate no matter your age.

Additionally, the withdrawal amount is added to your ordinary income so you may be pushed into a higher tax bracket. If you pass away with money in your traditional IRA account, your beneficiaries may owe income tax on any withdrawals they make, depending on the circumstances.

There are special rules for inherited IRAs, so it’s a good idea for a beneficiary to consult a financial advisor to better understand the tax implications. They won’t owe income taxes from a Roth IRA withdrawal.

Making an early withdrawal from a traditional, SEP or SARSEP IRA will incur an extra 10% tax penalty. If you take money out of a SIMPLE IRA within the first two years of taking part in the plan, you’ll owe a 25% tax penalty. An early withdrawal of earnings from a Roth IRA could also be subject to the 10% penalty.

Tax penalties can eat into the money you take out. For example, if you withdraw $5,000 from a SIMPLE IRA that you’ve only been contributing to for one year, you will be left with only $3,750 before paying taxes on the distribution. Make sure your financial advisor weighs in before making an IRA withdrawal, to help you minimize any taxes.

Early withdrawal penalties for your IRA investments are almost always avoidable. Here are a few tips to help you minimize the penalties you pay.

Just as you did with your retirement planning, consult with a financial advisor or tax professional before making any unscheduled withdrawals from an IRA. Either can help you decide how to get the money you need while paying as little tax as possible.