Traditional individual retirement accounts (IRAs) can be a great way to save for the future because they offer a potential up-front tax deduction and allow you to defer taxes on any investment earnings in the account until you take money out. But getting the most out of your traditional IRA requires meeting certain requirements, both when you put money into your account and when you make withdrawals.
"Even if retirement is years down the road, it's important to understand withdrawal rules for IRAs and other tax-advantaged accounts," said Rob Williams, managing director of financial planning, retirement income, and wealth management at the Schwab Center for Financial Research. "These rules determine, among other things, when can you access your savings without penalties and how it will be taxed. Being aware of them ahead of time can help you avoid unnecessary costs and surprises."
Here are four questions to keep in mind when it comes to traditional IRA withdrawals.
#1: What's the earliest I can start withdrawing money from my traditional IRA without a penalty? Are there any exceptions?
Once you reach age 59½, you can begin withdrawing funds from your traditional IRA without any restrictions or penalties. Taking money out before then can result in a 10% penalty from the federal government, and a state penalty may also apply. There are some IRS-approved exceptions, though. You may be able to avoid a penalty if your withdrawal is for:
- First-time home purchase
- Educational expenses
- Disability or death
- Medical expenses
- Birth or adoption expenses
- Health insurance
- Periodic equal payments
- An involuntary distribution
- Reservist active duty
"Early withdrawal exceptions are there for investors who qualify," Rob explained. "But in most cases, you'll benefit more by leaving your money in the account for potential growth until retirement."
#2: How will withdrawals from my traditional IRA be taxed?
Traditional IRA pre-tax contributions and earnings are taxed when you take money out of your account. Withdrawals you make after age 59½ or due to an approved exception are generally taxed as ordinary income. So, the amount you'll owe depends on the income-tax bracket you fall into when you take money out and the corresponding tax rate.
"Minimizing taxes on retirement withdrawals becomes especially important when you start living off of your savings, because it can affect how long your money will last," said Hayden Adams, CPA, CFP, and director of tax planning and wealth management at the Schwab Center for Financial Research. "To help minimize taxes, consider making your traditional IRA and other tax-advantaged retirement accounts part of larger tax-efficient investment strategy. As you near retirement, you'll also want to put a tax-smart withdrawal strategy in place to help you get the most from your tax-advantaged and taxable accounts."
#3: I've heard I'll be required to start making withdrawals from my traditional IRA at a certain age?
This is true. Unlike a Roth IRA, traditional IRAs and other tax-deferred retirement accounts, are subject to required minimum distributions (RMDs).
Starting at age 73, you must start drawing down your traditional IRA balance by taking an annual RMD. If you fail to withdraw your full RMD by the deadline, you could owe a 25% penalty on the amount you failed to withdraw.
How much will your RMD be?
Once you reach RMD age, the amount you need to withdraw for the year depends on two things: your account balance on December 31 of the prior year and your distribution period (a number the IRS assigns to each age group, starting at 73). The IRS provides online worksheets to help you do the math.
You can also use Schwab's RMD calculator.
#4: What are the withdrawal rules if I inherit a traditional IRA?
The rules for withdrawing money from an inherited IRA are based on several factors, including when you inherited the account, your relationship to the original owner, and when the owner died. Depending on your situation, you may have the choice to take a lump-sum distribution, transfer the funds into your own IRA (spouse only), take distributions over your lifetime, or disclaim the inherited IRA so that it passes on to the next beneficiary in line. In some cases, you may be required to withdraw all money from the account within 10 years.
"The rules surrounding inherited IRAs have grown more complex in recent years," said Hayden. "And they can have an impact on your tax bill. So be sure to talk to an estate or financial planner as you explore your choices."
Withdrawals and distributions of taxable amounts are subject to ordinary income tax and, if made prior to age 59 1/2, may be subject to an additional 10% federal tax penalty, sometimes referred to as an additional income tax.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for their own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.
The Schwab Center for Financial Research is a division of Charles Schwab & Company, Inc.1123-3JS9