A traditional Individual Retirement Account (IRA) can be a great tool for retirement savings, but it can also be a fantastic tool for tax planning with some immediate tax advantages for those who qualify.
Tax Withdrawals from Traditional IRA
With the exception of recovering previous non-deductible contributions, all withdrawals from a traditional IRA are subject to ordinary taxes regardless of when the withdrawal is made. This is the nature of tax-deferred growth – taxes are simply deferred until you withdraw from the account.
Early Withdrawal Penalty
The real problem with withdrawals from a traditional IRA arises when they are taken before the age of 59.5. In addition to taxes that will be owed, a 10% penalty is imposed on early withdrawals if you have not yet reached this age when you take your first withdrawal from the IRA.
Exceptions to the Early Withdrawal Penalty on Traditional IRA
Penalty-free withdrawals from a traditional IRA before age 59.5 are allowed in certain circumstances. These circumstances are known as exceptions and include the following scenarios:
- In the case of death, and the account value is paid to your beneficiary.
- In the case of total and permanent disability.
- In the case of using the early withdrawal to pay unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (MAGI) or more than 10% if you are under age 65.
- In the case of unemployment for 12 weeks or more and using the early withdrawal from the IRA to pay for health insurance for yourself or for your spouse or dependents.
- In the case of beginning to take substantially equal periodic payments according to a regular distribution schedule. But beware: if you do this, you will be committed and cannot change your mind and withdraw the funds after payments have begun.
- In the case of using the withdrawal to pay for qualified higher education expenses for yourself, your spouse, your dependents, or your beneficiary.
- In the case of using the withdrawal of up to $10,000 to buy a qualified first home within 120 days of the time you make the withdrawal. This exception includes building or reconstructing a first home.
- In the case of being a member of the National Guard or Reserve who is called to active duty for at least 180 days, with some restrictions.
- In the case of rolling the funds into another IRA within 60 days of the withdrawal.
Taking early withdrawals from an IRA may not be the best financial move in some of these cases. You may avoid the additional 10% penalty, but you will lose all potential future growth of the funds in that retirement plan.
Required Minimum Distributions
You must start taking required minimum distributions (RMDs) by age 72 for those who were younger than age 70.5 before January 1, 2020, based on the rules of the SECURE Act enacted in late 2019. Those who reached age 70.5 before December 31, 2019, must continue RMDs as required under the old rules.
You can delay taking your initial RMD from your IRA plan and maximize the benefits of tax-deferred growth until April 1 of the year following the year you reach the age at which you must start RMDs. Doing so means you will need to take two distributions from the account in that calendar year, which could lead to significant tax in that year.
After the first RMD year, you must take your RMD in each subsequent year by December 31 of that calendar year.
Your RMD is calculated based on your traditional IRA account balance as of December 31 of the previous calendar year. It is calculated based on your age using the appropriate table from the IRS. Practically, IRA account holders must perform these calculations and report the number to the IRS.
Penalty
Not taking the full RMD is 50% of the difference between what should have been distributed and what was actually withdrawn. In addition to the penalty amount, taxes on the amount that should have been withdrawn are still due.
Source: https://www.thebalancemoney.com/traditional-ira-withdrawal-rules-and-regulations-2894483
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