When and How to Start IRA Withdrawals

Hopefully, when you went to open an IRA, you did so with the intention of using it for long term retirement needs. The IRA concept is ideally suited for retirement savings and any withdrawals prior to retirement will diminish your long term plans. However, even if you do use an IRA for retirement, emergencies do happen where you may need to get your hands on the money early.

There are a number of withdrawal rules that apply. The IRS calls these distribution rules. The rules also differ between a Traditional IRA vs Roth IRA.

Traditional IRA Withdrawals

In a Traditional IRA, you most probably took a tax deduction for the amounts you contributed to the plan. This was the reason for opening the IRA.

Since you got a tax deduction going in, all money coming out of an IRA is taxable as ordinary income, including your own contributions. State income tax also applies. This applies no matter when you take money out of a Traditional.

If you take a withdrawal from a Traditional IRA before age 59 ½, the rules also impose an additional 10% penalty on the amount withdrawn. This penalty will not apply to withdrawals under one of the exceptions noted below.

Required Minimum Withdrawals

Since you get a tax deduction of some contributions, some people may want to defer the eventual tax by withdrawals as long as possible. The one thing about the IRS is that they are perfectly willing to wait for their tax, but in the end they always get you.

The rules state that you must begin taking withdrawals no later than the April 1st following the year in which you reach age 70 ½. Thereafter, the withdrawals must be made by December 31st of each year. You can spread the tax by taking withdrawals over the remainder of your expected lifetime.

Even if you make a large withdrawal in a particular year either before or after age 70 12, you still need to meet the minimum withdrawal rules for the other years. In other words, you don’t get a credit against the minimum for taking out more in one year.

Exceptions to the Early Withdrawal Penalty in a Traditional IRA

If you take a withdrawal prior to age 59 ½, the IRS allows certain exceptions where you won’t get hit with a 10% penalty:

  • Unreimbursed Medical Expenses – The penalty won’t be imposed if your medical expenses are over 7.5% of your adjusted gross income for the year.
  • Medical Insurance – If you lost your job at work, received unemployment checks, and bought medical insurance for you and your family, the penalty won’t apply if you did not take the withdrawal more than 60 days after finding a new job.
  • Disability – The penalty won’t apply if you can’t do any gainful work due to physical or mental problems. This must be certified by a doctor.
  • IRA Beneficiary – If you die before age 59 1/2, your IRA can be withdrawn by your beneficiaries or estate without penalty.
  • Higher Education Expenses – If you paid expenses for higher education during the year, part (or all) of any distribution may not be subject to the 10% tax penalty.
  • First Time Homeowner – You can make an early withdrawal from an IRA if you use the money to purchase, rebuild, or build your first home. The distributions are limited to $10,000, and must be withdrawn no more than 120 days after making the purchase.
  • Rollover into another Qualified Plan – If the withdrawal is rolled over into another qualifying IRA plan in a timely manner, then it is not subject to the 10% early withdrawal penalty.
  • Annuity Distributions – the penalty won’t apply if your withdrawals are made that are part of a series of substantially equal payments. The payments must be over at least the later of 5 years or age 59 ½.

Again, these exceptions apply only to the penalty. All withdrawals are taxed as ordinary income without exception.

Roth IRA Withdrawals

Since you did not take a tax deduction for your contributions to a Roth IRA, all withdrawals made after the later of age 59 ½ or 5 years after you first opened the account, are totally tax free. This applies to your contributions plus earnings.

If you withdraw money prior to age 59 ½, your earnings will be subject to ordinary income tax plus a 10% penalty. However, the there is a tax advantage that applies to early withdrawals under a Roth, as explained under Tax Treatment of Withdrawals below.

Exception to the Early Withdrawal Penalty under a Roth IRA

There are only 3 exceptions to the early withdrawal rules.

  • Disability – The penalty won’t apply if you can’t do any gainful work due to physical or mental problems. This must be certified by a doctor.
  • IRA Beneficiary – If you die before age 59 1/2, your IRA can be withdrawn by your beneficiaries or estate without penalty.
  • First Time Homeowner – You can make an early withdrawal if the money is used to purchase the first home for yourself, parents, children or grandchildren. Qualified costs include the main home of a first time home buyer who is yourself, your spouse, your children, grandchildren, a parent, or another ancestor.

Tax Treatment of Withdrawals

  • Under all IRA’s, the earnings withdrawals before age 59 ½ are taxed as ordinary income and may get hit with a 10% penalty.
  • Under a Roth, earnings withdrawals are tax free if you are over 59 ½, and have been in a Roth for more than 5 years.
  • Under a Traditional, all your earnings distributions are considered Ordinary Income for tax purposes both over and under age 59 1/2.
  • Then you need to picture your retirement years. Will your tax bracket drop because you are no longer working? Or do you plan to never really retire, but just change careers into some type of money making hobby?
  • There is a special advantage in a Roth when you take early withdrawals. Any early withdrawals are considered as first taking out your own contributions. Once you have depleted all your own contributions, any further withdrawals come out of your earnings.

Using a Roth as a Cash Emergency Fund

The last tax advantage above is the reason many people use a Roth IRA as their Cash Emergency Fund. Should you have a leaky roof that needs to be fixed, or need a new car, you can make a withdrawal from your Roth IRA without any tax, assuming your contributions are more than the withdrawal amount. You should be aware, however, that you cannot simply put these amounts back into the Roth. Any contributions, either new or repayment of a withdrawal, come under the annual contribution limits of $5,000 ($6,000 if over age 50). So, think twice before withdrawing money from a Roth.

Taking IRA Withdrawals

In a Traditional, take withdrawals as late as possible so that you continue to defer taxes. With the Roth, take the withdrawals as you wish once you pass the age 59 ½ or 5 year rule if later. Do not use the Roth as a Cash Emergency Fund. This may be financially viable, but once you start taking withdrawals from this fund, it’s easy to get used to it. You will eventually have to start taking taxable earnings, which defeats the purpose of the Roth IRA.

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