As traditional pension plans seem to have gone the way of the dodo, U.S. workers are stashing their savings in their own retirement accounts. An increasing number of Americans are choosing to grow their nest egg through an Individual Retirement Account (IRA).
Since their inception in 1974, Americans have funneled trillions of dollars into these tax-advantaged accounts, both through direct contributions and through rollovers from employer-sponsored plans. The Employee Benefit Research Institute estimates there are some 25.8 million IRAs containing up to $2.46 trillion in assets in the U.S. today.
It’s no wonder IRAs are so popular with Americans. Not only are contributions to a traditional IRA usually tax-deductible, but the earnings in the account grow on a tax-deferred basis. In other words, if you have a traditional IRA, you will not be taxed on assets in the account until you withdraw them. This enables you to put off paying taxes until retirement, when you’ll most likely fall in a lower tax bracket.
To top it off, anyone younger than age 70½ with some form of income from work can open and contribute to a traditional IRA – whether he or she is employed by a company, self-employed or a non-working spouse depositing work income from their spouse's check.
But how exactly does a traditional IRA work after retirement? What happens when it’s time to tap into those tax-deferred IRA earnings?
Win, Lose or Withdraw
Technically, you can withdraw money (aka take distributions) from an IRA at any time. However, if you choose to take funds from your IRA before you hit the age of 59½, you’ll probably have to cough up a 10% early-withdrawal penalty in addition to paying income taxes. The taxes and penalty amount you’ll pay depends on your age at the time of the distribution and the tax-deductibility of the contributions (depending on whether or not you are also covered by an employer-sponsored retirement plan).
Note that 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. (For more on this, see 9 Penalty-Free IRA Withdrawals.) Also, you can take a penalty-free loan from your IRA if you 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.”
Once you reach the magic age of 59½, you can start taking distributions from your IRA penalty-free – though, of course, they're still subject to income taxes. However, you are not required to start taking distributions as soon as you reach 59½ or even once you retire. In fact, you can defer distributions for more than a decade after that milestone half birthday.
The next IRA milestone half birthday is 70½, after which you must start taking required minimum distributions (RMDs) from traditional IRA accounts. At that time, you can either withdraw the full balance of the IRA, just withdraw the minimum amount each year – or take out a figure in between.
You have to take your first required minimum distribution by April 1 of the year after you reach age 70½. If you turn 70½ in August 2017, you must take your first RMD by April 1, 2018. If you choose to take a minimum distribution, you must do it by December 31 of each year. If you choose to delay your first RMD until April 1 of the year after you turn 70½, you’ll be required to take a second RMD amount in that same year, which counts as the second year for RMDs.
Seems like a lot to remember, right? No worries. Usually, the IRA custodian, or financial institution, will calculate your RMD amount and notify you about upcoming distribution deadlines. And “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.
What happens if you don’t take your required IRA distributions after your 70½ birthday? “Failing to take an RMD on time can have very serious consequences,” says Christopher Gething, founder of Atherean Wealth Management, Jersey City, N.J. “Unless you are able to convince the IRS that failing to take the distribution was due to a reasonable error, you will be subjected to a penalty tax of 50% of the missed distribution.”
Although you’re required to start taking distributions from your IRA at age 70½, this doesn’t mean you have to spend the money. Determine how to best allocate these funds based on your overall retirement income plan. If you don’t absolutely need the cash for living expenses, you may choose to put those IRA distributions back to work.
For example, you might consider purchasing an annuity to turn your assets into a stream of income payments that’s guaranteed for life. (There are some limitations on the types of annuities you can fund with RMDs, so check with a tax pro before you choose one.) Or you could decide to reinvest the distributions from your IRA into municipal bonds, stocks, mutual funds or exchange-traded funds (ETFs).
Another alternative: converting your traditional IRA assets to a Roth IRA. If you do this, you’ll no longer have to worry about RMDs and your distributions will not be taxable. This is particularly appealing to IRA holders who want to leave a legacy. Because a Roth IRA has no RMDs during your lifetime, you can leave the assets in place, allow them to grow tax-free and bequeath the account itself to your survivors. However, you will likely incur a hefty tax bill the year you employ this strategy. (For more on this, see Converting Traditional IRA Savings to a Roth IRA.)
The Bottom Line
When it comes to traditional IRAs, there are 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 you don't spend them. Start planning well before the milestone age of 70½. Given all the government regulations involved, you don't want to have to make any sudden moves with your IRA.