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 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:
-- 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 72.
-- Your IRA withdrawals could affect your Medicare premiums.
-- You may be able to avoid an early withdraw penalty in certain circumstances.
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discourage people from tapping into their account before retirement, the government imposes a 10% tax penalty on money withdrawn before age 59 1/2.
"IRAs are designed for retirement, and the government wants to ensure the money is used for that," says Stuart Chamberlin, president of Chamberlin Financial Inc. in Boca Raton, Florida.
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 For someone in the 12% tax bracket, the added penalty could mean nearly a quarter of the amount withdrawn will be eaten up by taxes and the penalty.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 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 Barrington, 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. "In most cases, it may make sense to 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% 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 72
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 72. The year 2020 is the one exception to this rule with the CARES Act, passed in response to the COVID-19 pandemic, waiving the requirement for this year.
In any other year, failure to take these annual distributions results in a tax penalty equal to 50% of the required distribution amount. Piershale notes a person with a $700,000 retirement account may have an RMD around $27,000. That means missing the deadline to withdraw the RMD would cost that person $13,500 in penalties.
"The money in these accounts hasn't yet been taxed," says John Mantia, co-founder and director of finance for PARCO, a firm based in Washington, D.C., that specializes in helping federal employees navigate their retirement benefits. By requiring RMDs, the government ensures that this cash is not tax-deferred indefinitely.
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. The more money converted or withdrawn prior to age 72, the lower RMDs will be later in life. That lower RMD could then translate to reduced taxes.
"If you don't need the money, plan out how much to move over to a Roth account," Mantia advises. However, be aware that money converted to a Roth account cannot be considered an RMD once you reach age 72.
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 2020 is $144.60 a month, those with higher incomes could pay significantly more.
In 2020, people who have modified gross incomes greater than $87,000 start paying additional premiums for Medicare Part B and prescription drug coverage. Married couples filing jointly with modified gross incomes of $174,000 or more will also have additional premiums. The government goes back two years when determining your income level. For example, in 2020, data from tax year 2018 is used for calculating Medicare premium payments.
These higher premiums start at $202.40 per month and go to as much as $491.60 a month for single taxpayers with incomes of $500,000 or more.
You May Be Able to Avoid an Early Withdraw 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.
"On a traditional IRA, generally you can't withdraw until 59 1/2, 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.
What's more, the CARES Act allows those affected by COVID-19 to withdraw up to $100,000 in 2020 and not pay a penalty. This option is available to those who have been diagnosed with COVID-19 or who have a spouse or dependent who was diagnosed using a CDC-approved test. A penalty-free withdrawal can also be taken by those experiencing a wide range of adverse effects from the pandemic, including a lost job or reduction in hours.
Although money used for an eligible purpose is not subject to a penalty, income taxes still apply. For withdrawals related to COVID-19, the IRS allows people to spread their income tax payments over a three-year period.
Another option to avoiding the early withdrawal penalty is to take at least five substantially equal periodic payments as allowed under IRS rule 72(t). "Very few people use that," Chamberlin 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 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.