An individual retirement account (IRA), as the name implies, is a place to store those golden nest eggs for the golden years. But here's an interesting fact: Many senior workers and new retirees are still building their IRAs. More than half of the IRAs owned by those near or in retirement (60 or older) saw balance increases over a recent three-year period, according to the Employee Benefit Research Institute. Even among IRAs owned by retirees (ages 71 to 74) who are just starting to take required minimum distributions (RMDs), nearly half of the accounts had increasing balances during this period.

All of which raises an interesting question: How does a traditional IRA work after retirement? What happens when it’s time to tap into those tax-deferred IRA earnings?

IRA Early Withdrawals

Technically, the owner of an IRA can withdraw money (taking distributions, in IRS-speak) from an IRA at any time. If it happens before age 59½, though, the account owner will probably incur a 10% early-withdrawal penalty in addition to income taxes. The taxes and penalty amount also depends on the tax-deductibility of the contributions (determined by whether the account owner also has an employer-sponsored retirement plan).

Key Takeaways

  • At age 59½, an account owner can start taking distributions from a traditional IRA penalty-free—though of course, they're still subject to income taxes.
  • IRA owners can defer distributions for several years after reaching full retirement age: Distributions aren't required until age 70½.
  • Required minimum distributions don't have to be spent. They can be invested in an annuity or rolled over into a Roth IRA.

The IRS will waive this penalty when distributions are used for specific purposes, such as unreimbursed medical expenses, health insurance, qualified higher education expenses, or to purchase a first home. An account owner can also take a penalty-free loan from the IRA if they replace the money within 60 days.

“A little-known strategy to access IRA funds without penalty before age 59½ is the ‘reverse rollover,’” says James B. Twining, founder of Financial Plan, Inc. in Bellingham, Wash. “This technique will work for those who are age 55 or older and have a 401(k) that accepts rollovers and allows for early retirement withdrawals at age 55. With this technique, IRA funds are first rolled into the 401(k), then the 401(k) funds are withdrawn without penalty.”

At age 59½, an account owner can start taking distributions from the IRA penalty-free—though of course, they're still subject to income taxes. IRA owners are not required to start taking distributions at 59½ or even once they retire. Owners can defer distributions for more than a decade after turning 60.

How Required Minimum Distributions Work

The next IRA milestone age is 70½, after which an account owner must start taking RMDs from traditional IRAs. At that time, withdrawals can be either the full balance of the IRA, the minimum amount each year, or a figure in between.

The first RMD must be taken by April 1 of the year after the account owner turns age 70½. For example, if the owner reaches 70½ in August, the first RMD must be taken by the following April 1. Minimum distributions must be taken by Dec. 31 of each year. So if the owner of the account delays the first RMD until April 1 of the year after they turn 70½, they're required to take a second RMD in that same year, which counts as the second year for RMDs. Usually, the IRA custodian, or financial institution, will calculate the RMD and notify the account owner about upcoming distribution deadlines.

What happens if the account owner doesn't take RMDs after they reach age 70½? “Failing to take an RMD on time can have very serious consequences,” says Christopher Gething, founder of Atherean Wealth Management, Jersey City, New Jersey. “Unless you are able to convince the IRS that failing to take the distribution was due to a reasonable error, you will be subject to a penalty tax of 50% of the missed distribution.”

"If you have multiple IRA accounts and one has been performing poorly, you can take the [full] RMD from the poorest-performing IRA to satisfy the RMDs on all of them,” says Carlos Dias Jr, founder of Excel Tax & Wealth Group in Lake Mary, Fla.

IRA Withdrawal Strategies

Just because RMDs have to be taken doesn't mean they have to be spent. There are several strategies to employ with the funds.

For example, purchasing an annuity can turn assets into a stream of income payments for life. (There are some limitations on the types of annuities to fund with RMDs, so check with a tax pro.) Distributions can also be reinvested in municipal bonds, stocks, mutual funds, or exchange-traded funds.

Another alternative: depositing your RMDs into a Roth IRA. You'll still have to pay income taxes on them, but the funds will be allowed to grow tax-free thereafter, and you are not obligated to take them out at any time or in any amount. The assets can be left in place, and bequeathed to survivors. If you do withdraw them, they won't be taxable, provided you hold the Roth account for five years.

In fact, you can convert the entire traditional IRA account to a Roth IRA. This is an especially good strategy if your tax bracket in retirement is actually going to be higher than it was in your working days. However, bear in mind you will owe income taxes on the entire account in the year you convert: In other words, you'll likely incur a hefty tax bill in the short run.

The Bottom Line

Traditional IRAs have many complicated distribution and tax rules to keep in mind. It can be tricky to determine when and how much to withdraw, and how to reinvest the distributions if they aren't spent otherwise. Start planning well before the milestone age of 70½ to avoid having to make sudden moves with an IRA, and to determine how to best allocate these funds for maximum income and minimum taxes.