Individual retirement accounts, commonly known as IRAs, are retirement fund staples for many people. Traditional IRAs let workers take a tax deduction when they deposit money into their account, and then pay taxes when they withdraw the money.
It sounds straightforward, but exactly when you withdraw that money can make a big difference in how much you end up paying the government in taxes and fees.
Here are five things you should know before pulling money from your traditional IRA.
1. You could pay a penalty if you withdraw money too early.
The trade-off for the tax deduction on traditional IRA contributions is a restriction on when you can withdraw money from the account. To discourage people from tapping into their account before retirement, the government imposes a 10 percent tax penalty on money withdrawn before age 59 ½.
That penalty is on top of income taxes that need to be paid on a withdrawal. For someone in the 15 percent tax bracket, the added penalty could mean a quarter of the amount withdrawn will be eaten up by taxes and the penalty.
2. You could miss a window for tax savings if you withdraw too late.
While you don’t want to pull money from your IRA too early, waiting too long to start disbursements can be a mistake as well.
“When you retire, often people have what I call this ‘window of opportunity’ where they have low income years,” says Mike Piershale, president of Piershale Financial Group in Crystal Lake, Illinois.
Piershale says those first years of retirement can be the perfect time to convert money from a traditional IRA to a Roth IRA. You will pay taxes on the money you convert, but a Roth IRA will allow the fund to continue growing tax-free. “Convert just enough to keep you in the same tax bracket,” he says, noting you don’t want to inadvertently bump yourself into a higher tax bracket.
Another reason to withdraw money from an IRA earlier rather than later is to delay claiming Social Security benefits. You get an 8 percent increase in benefits for every year you wait to claim from your full retirement age — currently age 66 for those retiring this year — until age 70. By instead withdrawing money from an IRA before age 70, you could delay the start of Social Security and maximize those benefits.
3. You are required to make minimum withdrawals from traditional IRAs once you reach age 70 ½.
Regardless of whether you withdrew money from your IRA earlier, everyone with a traditional IRA must begin taking required minimum distributions, or RMDs, at age 70 ½.
Failure to take these annual distributions results in a tax penalty equal to 50 percent of the required distribution amount. Piershale notes a person with a $700,000 retirement account may have a RMD around $25,000. That means missing the deadline to withdraw the RMD would cost that person $12,500 in penalties.
“You have to look at accounts collectively and individually. Each account can have its own distribution amount,” says Leslie Thompson, a certified financial planner at Spectrum Management Group in Indianapolis. “[The RMD] is where a lot of mistakes happen.”
The RMD is also why it makes sense to convert or withdraw money from a traditional IRA during a low-income period early in retirement.
“Because you’re taking money out early, your RMD at age 70 ½ will be less,” says Don Chamberlin, president and CEO of The Chamberlin Group in St. Louis, Missouri. The lower RMD could then result in lower taxes. “That’s a strategy we use quite often because many people have a good portion of their assets in qualified retirement plans,” he adds.
4. Your IRA withdrawals could affect your Medicare premiums.
In addition to taxes, the RMD and other IRA withdrawals can affect Medicare payments. “It has implications for what you pay for Part B premiums,” Thompson says. “Higher income people pay more.”
In 2015, people with modified gross incomes greater than $85,000 will pay additional premiums for Medicare Part B and prescription drug coverage. Married couples filing jointly with modified gross incomes $170,000 or more will also have additional premiums. The government goes back two years when determining your income level. For example, in 2015, data from tax year 2013 is used for calculating Medicare premium payments.
5. You may be able to avoid an early withdraw penalty in certain circumstances.
Although money in a traditional IRA is meant to be preserved for retirement, the government does allow workers to tap into the fund, without penalty, for certain purposes.
“On a traditional IRA, generally you can’t withdraw until 59 ½, although there are all sorts of exceptions,” Piershale says. Those exceptions include the following:
— A disability leaving you unable to work indefinitely
— Terminal illness
— Medical expenses
— Tax payments
— Higher education expenses
— Home purchases for first-time buyers
— Health insurance during periods of unemployment
Although money used for an eligible purpose is not subject to a penalty, income taxes still apply. In addition, the decision to raid a retirement fund should not to be taken lightly. A financial advisor can help you understand if you’re eligible to withdraw money without penalty and, if so, how that may affect your ability to retire comfortably in the years ahead.
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5 Things to Know About Withdrawing Money From a Traditional IRA originally appeared on usnews.com
