How much you will pay in taxes on an Individual Retirement Account (IRA) withdrawal depends on three factors:
1. The type of IRA
2. Your age
3. The purpose of the withdrawal
Sometimes the answer is zero (you owe no taxes). In other cases, you owe income tax on the money and sometimes an additional penalty if you withdraw funds before age 59.5. On the other hand, after a certain age, you may be required to withdraw money and pay taxes on it. The information below can help you think ahead about which type of IRA makes the most sense for you.
There are a number of IRA options: For this article we look primarily at the Roth IRA and the traditional IRA, which are the most broadly used. The withdrawal rules for the other types of IRAs are similar to the traditional IRA, with some minor unique differences. Other types of IRAs are the SEP-IRA, Simple IRA or SARSEP IRA. Each type has different rules about who can open one.
Tax-free Withdrawals: Roth IRAs Only
When you invest using a Roth IRA, you deposit the money after it has already been taxed. When you withdraw the money in retirement you pay no tax on the money you withdraw, or on any gains you made on your investments – a significant benefit. To take advantage of this tax-free withdrawal, the money must have been deposited in the IRA for at least five years and you must be at least 59.5.
If you need the money before that time, you can take out your contributions with no tax penalty as long as you don't touch any of the investment gains. You will need to keep a careful log of the money withdrawn prior to 59.5 and be sure to tell the trustee to only use contributions if withdrawing funds early. If you do not do this, you could be charged the same early-withdrawal penalties charged for taking money out of a traditional IRA (see below).
Knowing you can take out money penalty-free if you need to may give you the confidence to invest more in a Roth than you'd otherwise feel comfortable doing. If you really want to have enough for retirement, it's of course best to avoid taking out money before then.
Biggest Tax Bills
Money deposited in a traditional IRA is treated differently from money in a Roth. That's because the money you deposit is pre-tax income; each dollar you deposit reduces your taxable income by that amount. When you take out the money, both the initial investment and the gains it earned are taxed at your income tax rate in the year you withdraw it.
But if you withdraw money before you reach age 59.5, you will be assessed a 10% penalty in addition to regular income tax based on your tax bracket. There are some exceptions to this penalty (see below). You can also owe a 10% penalty if you accidentally withdraw investment earnings rather than only contributions from a Roth IRA before you are 59.5. That's why you need to keep careful records, as described above.
Ways to Avoid the Early-Withdrawal Tax Penalty
There are some hardship exceptions to being charged a penalty for withdrawing money before you reach 59.5 from a traditional IRA or the investment portion of a Roth IRA. Some common exceptions (for you or your estate) include:
- After the death of the IRA owner
- Total and permanent disability of the IRA owner
- Required distribution as part of a domestic relations order (divorce)
- Qualified education expenses
- Qualified first-time home purchase
- An IRA's levy on the plan
- Unreimbursed medical expenses
- A call to duty of a military reservist
One other way to escape the tax penalty: If you make an IRA deposit and change your mind by the extended due date of that year's tax return, you can withdraw it without owing the penalty. (Of course, that cash will be added to the year's taxable income.)
The other time you risk a tax penalty for early withdrawal is when you are rolling over the money from one IRA into another qualified IRA. The safest way to accomplish this goal is to work with your IRA trustee to arrange a trustee-to-trustee rollover. If you make a mistake trying to roll over the money without the help of a trustee, you could end up owing taxes.
You should not mix Roth IRA funds with the other types of IRAs. If you do, the Roth IRA funds will become taxable.
Regular Income Tax Only
Once you reach age 59.5, you can withdraw money without a 10% penalty from any type of IRA. If it's a Roth IRA, you won't owe any income tax. If it's not you will.
If the money is deposited in a traditional IRA, SEP IRA, Simple IRA or SARSEP IRA you will owe taxes at your current tax rate on the amount you take out. For example, if you are in the 15% tax bracket, your withdrawal will be taxed at 15%. You won't owe any income tax as long as you leave your money in a non-Roth IRA – until you hit another key age milestone.
Required Minimum Distributions
Once you reach 70.5, you will be required to take a minimum distribution from a traditional IRA. The IRS has very specific rules about how much you must take out each year. This is called the required minimum distribution (RMD). If you fail to take out the required amount you could be socked with a 50% tax on the amount not distributed as required.
You can avoid the RMD completely if you have a Roth IRA. There are no RMD requirements for your Roth IRA, but if money remains after your death your beneficiaries may have to pay taxes. They are several different ways your beneficiaries can withdraw the funds and they should seek advice from a financial advisor or the Roth trustee.
The Bottom Line
Money you deposit in an IRA should be money you plan to set aside for retirement, but sometimes unexpected circumstances get in the way. If you are considering withdrawing money prior to retirement, be sure you understand the rules regarding an IRA penalty and try to avoid that extra 10% payment to the IRS. If you think you may need emergency funds before retirement, use a Roth IRA for those funds rather than a traditional IRA.