Understanding IRA Types
Traditional IRA
A traditional IRA (not to be confused with a SIMPLE IRA) is a tax-advantaged retirement savings account that allows you to contribute a pre-tax income which reduces your taxable income for the calendar year in which you make contributions. It's designed to help you grow your savings over time as investments within the account can appreciate without being taxed (until you withdraw the funds). Your traditional IRA contributions may be tax-deductible depending on your income and whether you have access to an employer-sponsored retirement plan such as a 401(k).
Traditional IRA withdrawal amounts are subject to regular income tax when you reach the age of retirement and start drawing from your IRA account, which is why it's essential to plan your withdrawals strategically so you can minimize your federal tax liability.
Roth IRA
A Roth IRA is a retirement account that allows you to contribute after-tax dollars toward your retirement savings. Unlike a traditional IRA, Roth IRA contributions are made with money that has already been taxed as opposed to being tax-deductible. The main advantage of a Roth account is that both your contributions and your earnings on those contributions grow tax-free, and you can enjoy tax-free Roth IRA withdrawals after you reach the age of 59½ if you've had the account open for at least 5 years.
If you anticipate being in a higher tax bracket when you retire, this is probably the IRA for you as you'll enjoy tax-free income without the burden of future taxes on your withdrawals. Plus, Roth IRAs offer excellent flexibility and allow you to withdraw contributions at any time without penalty.
Inherited IRA
An inherited IRA is a retirement account that is opened when you inherit an IRA or employer-sponsored retirement plan such as a 401(k) after the original IRA owner dies. You can be the beneficiary of an IRA whether you're a spouse, relative, entity, or unrelated party, though there are rules for handling an inherited IRA that differ for spouses versus non-spouses. For example, the SECURE Act mandated that non-spousal beneficiaries must withdraw all funds from an inherited IRA within 10 years, though there are a few exceptions. You also can't make additional contributions to an inherited IRA, and you'll be required to take minimum distributions (RMDs) once you turn 73.
If you inherit a Roth IRA from someone who has passed, you'll need to take RMDs (unlike the original account owner), but the funds will remain tax-free and protected from any early withdrawal penalty—even if you're younger than 59½.
Age Requirements for Withdrawals
General Age for Withdrawals
As far as IRA withdrawal rules go, the general age for withdrawing without incurring penalties is 59½ and applies to both traditional and Roth IRAs. If you wish to withdraw funds before this milestone you should make yourself aware of potential penalties and exceptions pertaining to your situation. It's also worth noting that there's no requirement to begin drawing from your IRA at 59½, and you're more than welcome to leave your savings to grow tax-deferred or tax-free until you need them (depending on the IRA type).
Age 59½: The Penalty-Free Threshold
The reason 59 ½ is so important is because it marks the age at which you can start drawing from your IRA without facing a 10% early withdrawal penalty. There are some notable exceptions, but this is the general rule. As mentioned, you can withdraw contributions from Roth IRAs at any time without penalty, but the earnings from those contributions would still be subject to penalty if withdrawn before you reach 59½.
Required Minimum Distributions (RMDs)
While you aren't required to withdraw funds from your IRA as soon as you hit the penalty-free withdrawal threshold, you will need to start once you turn 73 (unless you have a Roth IRA). At this age, RMDs come into play and represent the minimum amount you need to take out each year based on the life expectancy factor and the remaining account balance. If you don't withdraw when you're supposed to, you can face a 25% penalty on the amount that should have been taken—so it pays (or rather, doesn't cost) to keep track of every withdrawal.
Early Withdrawals: Penalties and Exceptions
If you take an early distribution from your IRA before you reach age 59½ you'll face the dreaded 10% penalty and the withdrawal will be subject to ordinary income taxes. That said, there are exceptions that may allow you to access retirement savings funds without penalty in extenuating circumstances.
- Hardship withdrawals may be permitted for immediate and heavy financial needs such as for funeral expenses, unreimbursed medical expenses, home damage, or to help with higher education expenses.
- Buyers looking at a first-time home purchase can withdraw up to $10,000 from their IRA penalty-free to help with purchasing a home.
- Other exceptions can be made for adoption or disability expenses.
Tax Implications of Withdrawals
Contributions to your IRA are made with pre-tax dollars, meaning that any amount you withdraw must be included as taxable income and reported to the IRS on your tax return using a Form 1099-R (in the case of traditional IRAs). Withdrawing earnings from a Roth IRA, however, is tax-free as long as you're at least 59½ and have had the account open for a minimum of 5 years. Those funds aren't reported as taxable income, but you should make sure to keep accurate records to verify the age of the account and your contribution history.
Strategies for Withdrawal
If you get strategic about the timing and balancing of your withdrawals as well as planning for RMDs (Required Minimum Distributions), it can make a big impact on your tax liability. Here are a few tips to remember:
- Withdrawing during years when you have lower taxable income prevents you from entering a higher tax bracket and paying a higher tax rate.
- Balancing withdrawals with your investment growth by only taking what you need can help you preserve your nest egg for longer.
- Planning for RMDs can save you from paying steep penalties.
