Traditional IRAs can be excellent ways to save for retirement while getting some nice tax breaks at the same time. However, income you use to contribute to your traditional IRA isn't exactly tax-free. Rather, it's tax-deferred, meaning that there are tax consequences on distributions. Here's what you need to know when making a withdrawal from your traditional IRA.
If you're over 59 1/2 years old
If your traditional IRA contributions were deductible when you made them, the most common scenario, any distributions from the account will be treated as ordinary income for tax purposes. If you happen to have any non-deductible contributions, only the portions that represent investment profits (not your original contributions) will be taxable. However, non-deductible traditional IRA contributions are pretty rare.
For this reason, you should consider the tax consequences before taking a large distribution from your traditional IRA, especially if you're still working. As an example, let's say you're single, are 60 years old, and have income of $50,000 per year from your job. After subtracting your deductions and exemptions, we'll say that you have $30,000 in taxable income, which puts you in the 15% tax bracket.
However, if you decide to take a $30,000 distribution from your traditional IRA in addition to your employment income, this makes your taxable income $60,000 – which puts you well into the 25% bracket. According to the 2016 IRS tax brackets, this $30,000 distribution would result in an additional $6,735 in federal tax liability, in addition to the state taxes you may have to pay on the distribution.
The point is that while tax consequences shouldn't necessarily prohibit you from using your money, they should definitely be considered. In the preceding example, you could save thousands by waiting until you're actually retired to start taking distributions.
Once you turn 70 1/2 years old, you'll be required to take annual distributions from your traditional IRA. The amount you'll need to withdraw is determined by your account balance and your life expectancy at the time according to IRS tables. You have the option of taking these mandatory distributions as a lump sum or as a series of payments spread throughout the year.
When it comes to required minimum distributions (RMDs), there is one potentially costly tax mistake to avoid. The IRS rules say that you need to withdraw your first required distribution by April 1 of the year following the calendar year in which you turn 70 1/2. However, subsequent distributions must be taken by Dec. 31 of each year.
So if you turn 70 1/2 in October 2016, you'll have until April 1, 2017, to take your first RMD. However, your second one will need to be taken by Dec. 31, 2017. By waiting until the last minute to take your first distribution, you'll have two years' worth of retirement distributions counted toward your taxable income during the same tax year. It's generally a better idea to take your first distribution by Dec. 31 of the year you turn 70-1/2 to avoid landing in a higher tax bracket than you deserve.
If you're under 59 1/2 years old
Finally, there is an extra tax consequence you should be aware of. If you take a distribution from your traditional IRA before you turn 59 1/2, you'll be subject to an additional 10% penalty from the IRS unless you had a qualifying reason for the withdrawal.
One common exception is that up to $10,000 can be withdrawn penalty-free (but not tax-free) for a first-time home purchase. Or any amount can be withdrawn to pay qualifying higher-education expenses. Here's a complete list of the valid reasons for using traditional IRA funds early and avoiding a penalty.
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