Must-Ask Questions: Traditional IRA Withdrawals

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," says Rob Williams, head of financial planning and wealth management research at the Schwab Center for Financial Research. "These rules determine, among other things, when you can 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.

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, however, some IRS-approved exceptions. You may be able to avoid a penalty on all or some of your withdrawal—depending on the amount—if your distribution is for:

• Substantially equal periodic payments
• First-time home purchase
• Educational expenses
• Disability or death
• Disaster recovery expenses
• Medical expenses
• Birth or adoption expenses
• Health insurance premiums paid while unemployed
• Reservist called to active duty

Many exceptions only cover withdrawals up to a certain amount. For example, as listed above, there is an exception for a qualified first-time homebuyer, but only up to a withdrawal of $10,000.

"Early withdrawal exceptions are there for investors who need them," Rob explains. "But in most cases, you'll benefit more by leaving your money in the account for potential growth until retirement."

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.

"Planning for and then managing 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," says Hayden Adams, CPA, CFP, and director of tax planning and wealth management research at the Schwab Center for Financial Research. "To help manage 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."

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.

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," says 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."