Avoiding taxes on IRA withdrawals can prove to be a great benefit to any individual’s retirement plan. Here are some of the things people need to do to avoid paying withdrawal taxes inside their IRA.
In this article:
- Consider the Type of IRA: Traditional IRA vs. Roth IRA
- Consider the Rules on Early Withdrawals and Exemptions
- How to Avoid the Early Withdrawal Penalty
- How to Minimize Taxes Post-Retirement
- Required Minimum Distributions
Avoiding Taxes on IRA Withdrawals | What You Need to Know
Consider the Type of IRA: Traditional IRA vs. Roth IRA
Both have varying tax rules that give them certain advantages. Roth IRAs, however, are the better option when it comes to minimizing taxes during withdrawal.
- Traditional IRAs give investors a tax deduction when they make the contribution.
- Roth IRA account holders receive that tax break upon withdrawal.
Consider the Rules on Early Withdrawals and Exemptions
IRAs are meant to help people have a source of income after retirement. Thus, investors who withdraw money before retirement or reaching a certain age will be taxed.
But, again, this depends on the type of IRA an investor has.
A Roth IRA allows investors to withdraw money without being taxed. If they make early withdrawals, these can also be tax-free provided that the money they withdraw comes solely from the contributions, and not the earnings of the investment.
- An investor contributes a total of $10,000 to their Roth IRA.
- That investor can then take out $10,000 without having to pay any taxes. Any money withdrawn beyond the $10,000 contribution (if there have been earnings) incurs income taxes on the withdrawn amount.
Depending on the investor’s age when they withdraw money, they might also have to pay a 10% early withdrawal penalty.
Traditional IRAs may not be ideal for those who are avoiding taxes on IRA withdrawals.
The IRS considers Traditional IRA withdrawals as taxable income. Additionally, investors who withdraw money before reaching 59 1/2 years old also have to pay an early withdrawal penalty.
How to Avoid the Early Withdrawal Penalty
Depending on one’s circumstances, there are exceptions when it comes to paying taxes and the early withdrawal penalty.
1. Military Service – Members of the military reserves who are called up for a period of active duty can also withdraw money from their IRAs without needing to pay taxes. The period of active duty must last for a minimum of 180 days, and the withdrawals should be made while the investor is on active duty.
2. First Home – Investors are also allowed to withdraw up to $10,000 without having to pay taxes or penalties if they use the money to either build or purchase their first home.
3. Death – If an investor passes away before retiring, the beneficiary of the IRA can withdraw money without having to pay taxes.
4. Medical Insurance – Unemployed individuals can also withdraw money from their IRAs without needing to pay taxes as long as they use the money to purchase health insurance.
5. Tax lien – The IRS can place tax liens against an individual who can’t pay his or her current income tax. Individuals in such cases can withdraw money from their IRAs without penalties to pay back taxes.
6. School Expenses – Individuals and their family members who attend qualified colleges or universities can also withdraw money from their IRAs tax-free. They can use the funds to pay for school expenses such as room and board, books, or tuition fees.
7. Disability – The IRS allows individuals who become disabled and are unable to work to withdraw money from their IRAs penalty-free.
8. Periodic Payments – Investors can also divide their IRA into equal periodic payments depending on their life expectancy that the IRS calculates. To avoid penalties, the investor has to receive the periodic payments for a minimum of five years or until he or she turns 59 1/2, whichever comes first.
9. Medical Bills – Having medical bills that are over 10% of one’s adjusted gross income for the tax year will also qualify for penalty and tax-free withdrawals. Individuals who qualify can withdraw money from their IRAs to pay the bills that go over the limit.
How to Minimize Taxes Post-Retirement
Individuals who are 59 1/2 years old can make retirement withdrawals from their IRAs without paying the 10% early withdrawal penalty. This is regardless of their employment status.
Investors don’t need to pay taxes for withdrawals on Roth IRAs. However, Traditional IRA withdrawals will be taxed as income, and not the lower capital gains rate.
Traditional IRA withdrawals (which are considered income gains) can cause some investors to move up to a higher tax bracket. Fortunately, there is a way to avoid this.
Some investors choose to even out those withdrawals during retirement with their other IRA accounts.
- For example, investors who split savings between Traditional and Roth accounts might choose to withdraw money from both accounts every year. This helps them avoid a hefty tax hit at the end of the year.
- Some also choose to spend the money in the Roth IRA and a regular brokerage account. While doing this, they keep their savings inside the Traditional IRA.
- This strategy allows the money in the Traditional IRA to continue growing while deferring taxes. This technique, however, also has certain limitations.
- When the investor turns 70 1/2 years old, he or she has to start taking the Required Minimum Distributions (RMD) from the Traditional IRA. The IRS charges investors a 50% penalty on their calculated RMD if they fail to make mandatory annual withdrawals.
Required Minimum Distributions
What are Required Minimum Distributions? Required Minimum Distributions, or RMDs, are the mandatory minimum withdrawals that owners of Traditional, SEP, and SIMPLE IRAs are required to make upon reaching the age of 70 1/2. The IRS calculates an individual’s RMD by taking into account his or her life expectancy and account balance.
There are some people who view their IRAs as their savings account or as part of their retirement funds. However, there are also those who treat it as an inheritance for their heirs.
In such cases, these investors should keep in mind that inherited IRAs retain their tax status.
Owners of both Traditional and Roth accounts can pass their accounts down. Their withdrawals will also have similar tax rules that the original owner of the account enjoyed.
With the amount of time, work, and effort it takes to build retirement savings, it is no wonder people are looking for ways to make the most of them. Avoiding taxes on IRA withdrawals, if done correctly, can be a strategic part of an individual’s retirement plan.
Do you have other questions about avoiding taxes on IRA withdrawals? Ask us in the comments section below!