IRA Withdrawals Rules
It's a great and worthwhile goal to save for retirement, but sometimes you hit a bump on life's highway and have to take some of your money back out. There are several rules for withdrawals that apply before you reach retirement age, and others for when you're ready to retire and enjoy the fruits of your labors.
There are five main types of IRA withdrawals: early, regular withdrawals, Required Minimum Distributions (RMDs), Roth IRA withdrawals, and IRA rollovers or transfers. Somewhat different rules apply to each of them and to various situations.
Early IRA Withdrawals
IRAs are specifically designed to hold retirement savings. IRS rules say that the money is to be withdrawn during retirement, so if you withdraw funds from a traditional IRA early, before you reach age 59 1/2, the IRS will assess a 10% early withdrawal penalty tax. "Traditional" is the key word here, because different rules apply to Roth IRAs.
You must report any early withdrawals from your traditional IRA on your 1040 tax form and ordinary income taxes apply to this money as well. There are a few exceptions to the penalty tax, but no exceptions to the income tax. You may be able to avoid the penalty tax portion if your situation falls under the IRA withdrawal hardship rules.
Don't forget to report the withdrawal because the custodian of the IRA will report it to the IRS. You will owe taxes and penalties once they notice that you didn't claim the income.
Roth IRA Withdrawals
There's a lot of conflicting information out there about Roth IRAs where withdrawals are sometimes tax-free, but not always.
The great thing about a Roth is that you can withdraw your original contributions (although not any of the deposits that came from conversions or rollovers) at any time, at any age, with no taxes or penalties.
But if you withdraw the investment gain portion of your Roth IRA early before age 59 /12 or before you've had the Roth for five years, the taxes and penalties will apply. If it's a designated Roth account in a 401(k) plan, the rules are different.
As long as you follow the rules and use the Roth for your retirement years, then your withdrawals will be tax-free.
Normal IRA Distributions
You can take funds out of your traditional IRA and no penalty taxes will apply after you reach age 59 1/2. These are considered normal IRA distributions because you're using them for your retirement years.
Because you didn't pay taxes on the money when it originally went into your IRA, the amount withdrawn is included in your current taxable income—you must report it on your 1040 tax form.
The amount of tax you'll pay on an IRA distribution will depend on your tax bracket and your total taxable income after any deductions you can take that year. If your income is high, you'll pay taxes at a higher rate. If you have more deductions than you have income, you may pay no tax at all.
NOTE: A financial planner can help you figure out if you should convert some or all of your traditional IRA funds into a Roth IRA. There can be tax advantages to pay the taxes now instead of years later when you tax bracket is probably higher.
Required Minimum Distributions
The IRS requires that you start taking distributions from IRA accounts, 401(k)s, 403(b)s, 457 plans, and other tax-deferred retirement savings plans once you reach age 70 1/2. These required minimum distributions are often referred to as RMDs.
If you take only part or none of your RMD, the IRS rules require you to pay a 50-percent penalty on the amount of RMD not taken.
The amount you must take changes each year because it's based on a formula using your age and the prior year-end account balance. You're not required to take RMDs from a Roth IRA if you own the account, but you will have to take an RMD each year if you inherit a Roth.
Rollovers and Transfers
When you roll over a qualified retirement account, such as a lump sum from a pension plan, 401(k), or 403(b) into a new IRA, the IRS does not count this as a withdrawal. You can roll over accounts with no taxes or penalties, regardless of your age, if you follow the IRS rules.
When you move money from one IRA to another, this is called a transfer. If your IRA money goes directly from one financial institution to another and the money is never in your hands, transfers are tax- and penalty-free.
Likewise, if the IRA funds come to you and you put them back into a qualified account within 60 days, you'll be spared the taxes and penalties. But you can only do this once every 12 months or it may be considered a taxable distribution.