Traditional IRA Withdrawal Rules: When Penalties Do and Don't Apply
A traditional IRA is a great choice for anyone who wants to build retirement savings with tax advantages.
But, a common concern by investors is:
"How and when I can withdraw that money?"
It's an understandable question given that the money is designed for long-term savings--not to be touched until retirement age.
That said, life is unpredictable and your financial plans can change.
Here are the rules on how you can withdraw money from a traditional IRA, especially if you need to access it before retirement.
What is a Traditional IRA?
A traditional IRA is a tax-advantaged retirement account.
These accounts are opened outside of an employer, so you get to choose where to open them.
This gives you access to a wide variety of investments to help save for your retirement.
These accounts allow people to contribute money and get a tax deduction in many cases. This may help people lower their tax burden while they’re working.
The money grows in these accounts tax-free.
These features classify a traditional IRA as a tax-deferred investment account.
The downside is people have to pay taxes on the money when it is eventually withdrawn.
These accounts exist to help people save for retirement, so early withdrawals face early withdrawal penalties.
When You Can Withdraw From a Traditional IRA Penalty-Free
Ideally, you want to avoid withdrawing money from a traditional IRA early.
The early withdrawal penalty is 10%.
Additionally, you’ll have to pay taxes on the amount withdrawn.
To avoid this penalty, you must wait until you’re age 59 and ½.
Some exceptions do exist that allow you to withdraw some money penalty-free before age 59 and ½.
You Eventually Get Forced to Withdraw Money From Your IRA
When you contribute money to a traditional IRA, you usually get a tax break.
The government needs revenue to continue operations, though. They don’t want you leaving money in your traditional IRA forever.
Because earnings grow tax-free, too, they don’t get any money until you withdraw from your IRA.
Some people aren’t in a fortunate position to avoid withdrawing money from an IRA.
However, super savers and people that have planned their retirement well may be able to do so.
To counteract this possibility, IRAs have a concept called required minimum distributions (RMDs).
Required minimum distributions (RMDs)
Starting at age 72, the rules of an IRA force you to withdraw a portion of your balance every year.
The particular amount is determined by your account balance in your IRA and a life expectancy factor the IRS provides.
By making this required minimum distribution, you potentially have to pay taxes on the amounts withdrawn.
Your first RMD must be taken by April 1 of the year after you turn 72 years old. After that first RMD, you must take your RMD by December 31 of each following year.
You face a steep penalty if you miss taking a required minimum distribution.
You’ll have to pay 50% of the amount you were supposed to withdraw.
How Are Traditional IRA Withdrawals Taxed?
Now that you understand when you can and when you’re forced to withdraw money from a traditional IRA, how is it taxed?
Money withdrawn from a traditional IRA is taxed as ordinary income.
But what does that mean?
This income is taxed at your ordinary income tax rates.
These rates start as low as 10% and increase as your income increases.
Other rates includes 12%, 22%, 24%, 32%, 35% and 37%.
Your entire income isn’t taxed at your tax rate, though.
Only additional income that falls in the higher tax brackets is taxed at the rate.
The income that falls in the lower brackets are taxed at the lower rates.
This is different than investments in a taxable investment account.
Capital gains taxes
Because investments are typically capital assets, they’re taxed at capital gains tax rates in a taxable investment account.
While short-term capital gains tax rates are the same as ordinary income tax rates, long-term rates are different.
Long-term capital gains tax rates can be as low as 0% or as high as 20%.
To qualify for the long-term rates, you must hold the asset for more than a year before selling it.
Money withdrawn from a traditional IRA doesn’t qualify for long-term capital gains tax rates.
Early Withdrawals from Traditional IRAs
Early withdrawals from a traditional IRA require you to pay taxes plus a 10% early withdrawal penalty.
This penalty can be avoided in certain circumstances.
These may include withdrawals for:
- Unreimbursed medical expenses in excess of 10% of your adjusted gross income
- Paying health insurance premiums when unemployed in certain circumstances
- You become permanently disabled
- Up to $10,000 for a qualifying first time home purchase
- Qualified education expenses for certain family members at a qualifying school
- You take substantially equal periodic payments for at least five years or until you turn age 59 and ½, whichever is later
- Certain other situations
You must always pay taxes on your withdrawals, though, since the money has not yet been taxed.
How to Minimize Taxes on IRA Withdrawals
Minimizing taxes on IRA withdrawals can help you keep more of the money you withdraw.
The less money you withdraw, the less you’ll pay in taxes.
This is due to the way the federal income tax structure’s marginal tax works.
That said, people still need to withdraw money to meet their expenses.
For the best overall result, you’ll need to use several tools to minimize your tax liability.
Reduce taxable income
First, you can minimize the tax on your traditional IRA withdrawals by reducing your taxable income in other ways.
The standard deduction automatically takes care of this for you.
If you file single, you get a $12,550 standard deduction.
This increases to $25,100 for those filing married filing jointly.
Itemize your deductions
Alternatively, you can itemize your deductions.
This only makes sense if your itemized deductions exceed your standard deductions.
Itemized deductions include things such as:
- Qualifying mortgage interest paid
- Qualifying state and local income taxes paid
- Medical and dental expenses above 7.5% of your adjusted gross income
- State and local real estate taxes paid
- Certain charitable contributions
Other deductions also exist. These can lower your taxable income, too.
- Educator expenses deduction
- Health savings account deduction
- Student loan interest deduction
Any available tax credits
Another way to reduce the tax you owe is by taking advantage of any tax credits you qualify for.
Tax credits are better than a deduction.
A deduction lowers your taxable income by $1.
If your tax rate is 12%, it lowers your taxes by $0.12.
A tax credit lowers your tax owed by $1.
If you have a $1 credit, you pay $1 less in taxes.
There are many tax credits you may qualify for, depending on your unique situation.
Potential credits could include:
- Child and dependent care tax credit
- Credit for other dependents
- American opportunity credit
- Lifetime learning credit
- Elderly and disabled credit
- Saver’s tax credit
- Foreign tax credit
- Electric vehicle credit
People that have Roth IRAs have another tool at their disposal.
Qualifying Roth IRA withdrawals aren’t taxed.
This is because the money you contributed to the account initially already had tax paid on it.
This income won’t increase your taxable income.
You could carefully plan your traditional and Roth IRA withdrawals each year.
Ideally, you’d withdraw enough to minimize your tax liability while still having the money you need to pay your expenses.
Consult an Expert
Taxation is a tricky subject for IRA owners.
The federal income tax code is massive.
Rather than make a mistake you may regret, you’re best off consulting an expert before you make any tax moves.
You may want to consult a tax advisor, a financial planner or both.
A Certified Public Accountant (CPA) who prepares taxes for a living could help you develop a strategy to minimize your taxes while withdrawing the money you need from retirement accounts.
Another option is consulting a fee-only fiduciary financial planner.
These advisors are paid directly by you and do not accept commissions.
They must also provide advice in your best interests.
They can create retirement plans, including a withdrawal strategy, that help clients maximize retirement while minimizing taxes.
It’s important to consult these people before you start taking withdrawals.
After you make a withdrawal in a given year, it’s often too late to fix the tax consequences.
Frequently Asked Questions (FAQs)
People often have questions about how traditional IRA withdrawal rules work.
Here are some of the answers.
How often can I withdraw from my IRA?
You can withdraw from your IRA as often as you’d like.
When you reach age 72, you should keep in mind you must start taking required minimum distributions at least once per year.
If you don’t withdraw the required amount, you face a 50% penalty on the amount that should have been withdrawn.