After a lifetime of saving for retirement, you'll eventually need to consider how to take money out of your IRAs. Because IRA distributions have tax ramifications, it can be important to have money withheld from those distributions to cover any potential liability. Having at least a rough idea of the appropriate amount for withholding is essential to avoid any problems.
Why withholding taxes from IRA distributions can be smart
There's no rule that says that you have to have taxes withheld from an IRA distribution. In some cases, the financial institution that handles your IRA will have a policy to withhold a certain percentage of your distribution automatically, but you'll usually have the option to choose a different percentage, or choose not to have any money withheld at all.
The danger of having no money withheld from your IRA distributions is that the IRS can impose penalties if your tax bill exceeds a certain amount and you haven't made adequate payments of estimated taxes throughout the year. During one's working career, it's rare for this situation to come up, because taxes are automatically withheld from your paycheck in an amount that's designed to avoid penalties. Once you retire and rely more heavily on retirement account distributions, though, you'll probably have to have money withheld from IRA distributions unless you're willing to take on the added burden of paying quarterly estimates to the IRS out of your own pocket.
How much should you withhold?
The basic answer on the proper amount to withhold is to make sure your total withholding is enough to avoid penalties. There are two key rules that apply. First, you generally won't have to pay an underpayment penalty if your tax bill is less than $1,000 after you subtract any amounts withheld for taxes. Second, even if your tax bill is above that amount, you won't owe a penalty if you pay at least 90% of your total tax due for the year either by withholding, or in quarterly estimated tax payments. Alternatively, you can avoid penalties if you withhold or pay estimates equal to 100% of your tax bill for the previous year. This figure rises to 110% for high-income taxpayers with gross incomes of more than $150,000.
Obviously, this amount will differ greatly depending on how much money you withhold, and what other income you have. The reason the default withholding rate is 10%, though, is that it's generally a pretty good measure of the eventual tax liability that a typical taxpayer will owe on IRA distributions. If you're in a low tax bracket, and don't have a lot of other income, then withholding that 10% amount can be a reasonable starting point.
If you have substantial income, 10% withholding might not be enough. Consulting with an accountant to estimate your total tax liability is the best way to figure out what percentage is appropriate for withholding.
Two things to keep in mind
There are a couple of final points to consider. First, if you live in a state that has state income tax, then you'll need to think about having money withheld for that tax as well. Some states actually have mandatory withholding that you can't opt out of as you can with the federal tax.
Second, if you discover at the end of the year that you haven't had enough money withheld, you can always do a final year-end distribution with 100% withholding. You won't receive cash, but you'll get credit for the withholding, which could help you avoid penalties at the last minute.
Figuring out how much to withhold from an IRA distribution is more complex than it might sound. By looking at your taxes in advance, though, you can often come up with a percentage that will get the job done.
If you're new to IRAs, or you have questions we haven't covered here, head on over to our IRA Center. We cover how to get started, and you'll have access to the latest Foolish articles on IRAs.
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