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 make a withdrawal.
It sounds straightforward, but exactly when and how you withdraw that money can make a big difference in how much you end up paying in taxes and fees.
Here are seven things you should know before pulling money from your traditional IRA:
— You could pay a penalty if you withdraw money too early.
— You could miss a window for tax savings if you withdraw too late.
— You are required to make minimum withdrawals from traditional IRAs once you reach age 73.
— You can reduce taxes by sending required minimum distributions to a charity.
— Your IRA withdrawals could affect your Medicare premiums.
— Your income from an IRA could result in more of your Social Security being taxed.
— You may be able to avoid an early withdrawal penalty in certain circumstances.
[READ: How to Make a Last-Minute IRA Contribution.]
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 take penalty-free withdrawals from the account.
“You generally can take money from an IRA at any time,” says Katherine Tierney, senior retirement strategist with Edward Jones in St. Louis, Missouri. However, you will pay a price if you do so too early.
To discourage people from tapping into their account before retirement, the government imposes a 10% tax penalty on money withdrawn before age 59 1/2. The early withdrawal penalty is on top of income taxes that need to be paid. For someone in the 12% tax bracket, the added penalty could mean nearly a quarter of the amount withdrawn will be eaten up by taxes and the penalty.
You wouldn’t need to worry about this penalty if you made non-deductible contributions to a traditional IRA, says Joelle Spear, a financial advisor with Canby Financial Advisors in Framingham, Massachusetts. However, that is rare and won’t apply in most situations.
“Most people don’t do that,” she says.
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.
“Everything that comes out is 100% taxable,” says Cary Carbonaro, a senior vice president and director of the Women and Wealth division at financial firm ACM Wealth.
That means you ideally want to withdraw your money in low-income years when you’ll be in a lower tax bracket. For many people, the first years of retirement mean a drop in income and are a prime time to withdraw funds or 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.
“It’s nice to have some of your money in Roth (accounts) as a planning strategy,” Spear says.
She suggests ages 55-65 as a sweet spot for conversions. That’s when children may be grown and out of the house, and taxpayers may have additional funds to cover any taxes due on the converted amount.
Another reason to withdraw money from an IRA earlier rather than later is to delay claiming Social Security benefits. You get an 8% increase in benefits for every year you wait to claim from your full retirement age until age 70. By withdrawing money from an IRA before age 70, you could delay the start of Social Security and maximize those benefits.
Minimum Withdrawals From Traditional IRAs Required at 73
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 73. Money in a traditional IRA hasn’t been taxed yet, and by requiring RMDs, the government ensures that this cash is not tax-deferred indefinitely.
“For the longest time, the rule was 70 1/2 when you had to take money out of an IRA,” Carbonaro says.
That age was increased to 72 with the passage of the SECURE Act at the end of 2019. Then, the SECURE 2.0 Act of 2022 bumped the required minimum distribution age to 73. It will continue to increase until it reaches 75 in 2033. Failure to take these annual distributions results in a tax penalty equal to 25% of the required distribution amount.
The RMD is another reason why it makes sense to convert or withdraw money from a traditional IRA during a low-income period early in retirement. The more money converted or withdrawn prior to age 73, the lower RMDs will be later in life. That lower RMD could then translate to reduced taxes. However, be aware that money converted to a Roth account cannot be considered an RMD.
You Can Reduce Taxes by Sending Required Minimum Distributions to a Charity
Thanks to government rules regarding RMDs, “You really can’t avoid withdrawals forever,” Tierney says. But you may be able to avoid paying taxes on that money if you are charitably inclined.
Those who are at least 70 1/2 can make qualified charitable contributions — known as QCDs — from their IRA instead of taking an RMD. Up to $100,000 can be withdrawn in this way, and money must be sent directly from an IRA to a qualified charity to be eligible for tax exemption.
“The benefit of a QCD is that it satisfies your RMD requirement, and it can help reduce your tax bill,” Tierney explains.
[Read: How to Manage an Inherited IRA.]
IRA Withdrawals Could Affect Your Medicare Premiums
In addition to taxes, the RMD and other IRA withdrawals can affect Medicare payments. While the standard Part B premium for 2023 is $164.90 a month, those with higher incomes could pay significantly more.
In 2023, people who have modified gross incomes greater than $97,000 start paying additional premiums for Medicare Part B and prescription drug coverage. Married couples filing jointly with modified gross incomes of $194,000 or more will also have additional premiums. The government goes back two years when determining your income level. For example, in 2023, data from tax year 2021 is used for calculating Medicare premium payments.
These higher premiums start at $230.80 per month and go to as much as $560.50 a month for single taxpayers with incomes of $500,000 or more.
Income From an IRA Could Result in More of Your Social Security Being Taxed
IRA withdrawals could increase how much of your Social Security benefits are taxable as well.
“Every $100 you take from an IRA is like you earned $100,” Spear says.
The Social Security Administration uses a figure known as combined income to determine if and how Social Security benefits are taxable. This number is calculated by adding together a person’s adjusted gross income, nontaxable interest and half their Social Security benefits.
Once a single taxpayer’s combined income exceeds $25,000, up to 50% of their Social Security benefits could be taxed. At incomes of $34,000 or more, single taxpayers could see income tax on up to 85% of their benefits. For married couples filing jointly, these thresholds are $32,000 and $44,000, respectively.
You May Be Able to Avoid an Early Withdrawal Penalty
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.
“The big one is for first time homebuyers,” Spear says. Up to $10,000 can be withdrawn penalty-free for a qualified first-time home purchase.
Other exceptions include the following:
— A disability leaving you unable to work indefinitely.
— Terminal illness.
— Medical expenses.
— Tax payments.
— Higher education expenses.
— Health insurance during periods of unemployment.
— Qualified birth and adoption expenses, up to $5,000
“None of them allow you to avoid taxation,” Tierney notes. You will still pay income tax on the money, but a qualified early withdrawal will allow you to skip the 10% penalty.
Another option for avoiding the early withdrawal penalty is to take substantially equal periodic payments as allowed under IRS rule 72(t). That’s a route taken by one of Carbonaro’s clients.
“However, once you set it, you cannot change it until you’re 59 1/2 or five years, whichever is longer,” she says.
Since modifying a payment plan after its start can result in retroactive penalties, it is best to attempt 72(t) distributions only under the guidance of a finance professional.
The decision to raid a retirement fund should not 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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Update 03/28/23: This story was published at an earlier date and has been updated with new information.