It’s relatively easy to understand the advantages of a traditional Individual Retirement Account (IRA). According to the Internal Revenue Service (IRS), this savings vehicle helps you build a retirement nest egg by allowing your contributions that may be deductible on your tax returns. In addition, the earnings in the account are tax-deferred until you withdraw them.
But understanding withdrawals (or distributions) can be a little more challenging. Make a mistake in the process, and you may incur additional taxes and penalties. Here are five essential things to know about traditional IRA distributions.
1. You can withdraw money anytime you want from a traditional IRA — but you may face penalties.
Yes, that’s right, you can use the funds for whatever your heart desires, whether you’re working or retired. But keep in mind that no matter your employment status or your age, the money you withdraw will be taxed as regular income. And, if you’re under the age of 59½ at the time you tap into it, you may be hit with an additional 10 percent early-withdrawal penalty. That’s because the government really wants to encourage you to let that money grow — for a while.
2. There are a few exceptions to the early-withdrawal penalty.
Note those two little words: a few. The IRS may let you off the hook for the 10 percent penalty early-withdrawal penalty if you’re a qualified first-time homebuyer (withdrawals may not exceed $10,000) for example, or if you need to pay medical insurance premiums while you’re unemployed. A few other exceptions apply with regard to higher education expenses and military reservists.
3. You must start taking withdrawals by age 70½.
A traditional IRA is intended for use during retirement — thus the name Individual Retirement Account. So, the IRS requires you to crack open your nest egg when you reach age 70½. You have until April 1 of the following calendar year to make an initial withdrawal. How does that work? Let’s say you turn 70½ on June 30, 2016. You can delay the first withdrawal until April 1, 2017. If you do wait until the following year, however, there may be tax implications (see No. 5).
4. You must withdraw a minimum amount every year.
It’s called the required minimum distribution (RMD), and the IRS provides a worksheet to help you calculate the figure on its website. Of course, you can take more than the RMD if you want. The point is, if you skimp on your RMD, or skip it altogether, you may have to pay a 50 percent excise tax on the amount you failed to withdraw.
5. Delay your first withdrawal until the calendar year after you turn 70½, and you’ll end up taking two withdrawals in the same year.
Why? Because the IRS requires you to take out money annually no later than Dec. 31 beginning in the calendar year after you turn 70½. So if you reach 70½ on June 30, 2016, and choose to delay your initial withdrawal until April 1, 2017, you’ll be required to take a second distribution later that year. While it might be exciting to have more money in hand, both withdrawals will be taxed on your 2017 returns. If you want to avoid the double whammy, it’s better to take the initial withdrawal in the same calendar year you turn 70½.
These are some of the basics for managing a traditional IRA withdrawal. If you need help managing your IRA to make the most out of your retirement, talk to a financial advisor.