IRA Withdrawal Rules

IRAs are valuable savings tools for retirement- but what happens if and when you want to withdraw money? Several rules apply to traditional IRA and Roth IRA withdrawals that you must understand to maximize your savings opportunities and minimize potential taxes and penalties.

This guide covers the basic rules that apply when you withdraw funds, including early withdrawals, required minimum distributions, tax implications, and a few special scenarios.

Understanding Individual Retirement Accounts (IRAs)

An Individual Retirement Account (IRA) is a tax-advantaged way to save money long-term. They help people prepare for retirement and act as a source of income after a certain age.

The two most popular types of accounts are traditional IRAs and Roth IRAs. A traditional IRA is funded using pre-tax dollars, while Roth IRA contributions are after-tax. Both accounts let you build tax-deferred savings but in slightly different ways.

Annual contribution limits apply to these accounts. The total per year (combined) is $6,500 if you are younger than 50 and $7,500 for over 50’s. Deductions are not generally limited by dollar amount, but there are time restrictions- which we will explore below.

IRAs let you invest in many assets, stocks, and bonds. Treasury bills and ETFs are two of the popular options.

Purpose of an IRA

Types of IRAs: Traditional and Roth

Contribution and Deduction Limits

Investment Options within an IRA

IRA Withdrawal Basics

In most cases, IRA withdrawals made before age 59 1/2 carry penalties. Traditional IRA holders who withdraw before this age will pay regular income tax on the amount and a 10% early withdrawal penalty. Roth IRA holders only face early withdrawal penalties if the amount exceeds the total contributions and eats into the earnings.

Early Withdrawals: Consequences and Exceptions

Normal Withdrawals: Post 59½ Age Rule

Late Withdrawals: Required Minimum Distributions

Another age-based rule for traditional IRA holders is the RMD age. Once you reach 73, you must withdraw certain distributions annually. How much depends on your life expectancy and previous end-of-year balance on the account.

Tax Implications of IRA Withdrawals

Early withdrawals are taxed as normal income. The tax implications depend on your current tax bracket at the time of withdrawal.

There are no penalties on either type of IRA between the ages of 59.5 and 73, but you will pay taxes on withdrawals from a traditional IRA. Roth IRA withdrawals are tax-free if the account has been open for more than five years.

Taxable and Non-taxable Withdrawals

Federal and State Taxes on Withdrawals

Penalty-Free Withdrawals and Exceptions

Here are some exceptions to the early withdrawal rules.

• Total and permanently disabled account owners
• Beneficiaries after the owner’s death
• Health insurance premiums
• Unreimbursed medical expenses
• The birth or adoption of a child
• First home purchase
• IRS levy
• Some education expenses

Understanding the 10% Early Withdrawal Penalty

Specific Exceptions to Early Withdrawal Penalties

Roth IRA rules are a little different from traditional IRA withdrawal rules. In a nutshell, you are taxed only on withdrawals from earnings. Contributions can be withdrawn at any time without fees or taxes.

The Roth IRA five-year holding period is a general rule for all accounts. You cannot withdraw funds within five years of the first contribution without facing a penalty.

Roth IRA Specifics

Roth IRA Contributions vs. Earnings

Roth IRA Income and Contribution Limits

Contributions to a Roth IRA are made on an after-tax basis.

As mentioned earlier the ability depends on your income level, emphasizing the importance of understanding Roth contribution limits.  If you are filing your taxes as a single person, you must have a modified adjusted gross income of under $153,000 for tax year 2023.  For 2024, the number escalates to $161,000.  Should you file as a joint account, the number has to be under $228,000 for the year 2023 and that number bumps to $240,000 for 2024.  

If you are seeking to maximize the investment, you can contribute $6,500 if you are under the age of 50 and up to $7,500 if you are aged 50 or over.

For 2024, you can invest $7,000 under age 50, and $8,000 if you are over age 50.

The Five-Year Rule for Roth IRA

While the Roth IRA no doubt has it’s advantages, it’s important you know about the five year rule.  

While you can take your your investments in a Roth IRA at any time, you typically can’t withdraw any earnings from your investments unless it’s been five years since you first contributed to the Roth IRA.  if you withdraw early, you will be subject to income taxes and possibly a 10% penalty.

Qualified and Non-Qualified Distributions

A qualified distribution occurs when you decide to withdraw after the age of 59.5.  The only exception is if the owner passes away or suffers from a disability.

A non-qualified distribution happens when you withdraw prior to that period.

Roth IRA Conversion: Process and Tax Implications

You do have the ability to shift investments from a traditional IRA or even a 401(k) to a Roth IRA by doing a Roth IRA conversion.  

The amount that you decide to convert will be taxed at the time of conversion to your gross income for that tax year, which currently range from 10-37%.

Strategies to Minimize Tax on IRA Withdrawals

There are a number of ways you can minimize taxes on IRA withdrawals.  The first way is to take the minimum required distribution once you hit retirement age.  The others, I’ll speak about individually below.

Using a Roth IRA or Roth 401(k)

The Backdoor Roth IRA Strategy

There is no required distribution on a Roth IRA account. Rolling over some of your savings means you can leave it there to grow tax-free. As long as it has been more than five years since your first Roth IRA contribution and you are over age 59 and a half, you don’t pay income taxes on any withdrawals- including Roth IRA earnings.

This is a good option if you intend to leave the contents of the Roth IRA to your heirs.

Substantially Equal Periodic Payments Rule

SEPP is a plan where account holders can withdraw funds without penalty for several years before reaching the minimum age. It generally applies to people who retire early for various reasons.

Tax-efficient Withdrawal Strategies

Unique IRA Withdrawal Scenarios

Inherited IRA: Rules and Distribution Options

Using IRA for Adoption or Higher Education

You can withdraw up to $5,000 within the first year of adopting a child without paying a penalty. Education for the account holder, their child, or their grandchild is another penalty-free exception- as long you prove the students attend a qualified institution. The tuition amount can be withdrawn, along with other qualified expenses.

IRA Distributions for Medical Expenses and Health Insurance

If you have medical expenses that are not covered by insurance exceeding 7.5% of your AGI, you can apply for a penalty-free IRA withdrawal to pay the extra. Penalties may also be waived on withdrawals to pay health insurance premiums while unemployed- as long as certain conditions are met.

IRA and IRS Levy: What You Should Know

The IRS can levy your IRA assets to recover taxes owed. They can do so at any time- regardless of age. You may incur taxes on an IRS levy but should not receive an additional penalty. Speak to a tax advisor for assistance.

Spousal IRA Withdrawal Rules

Spousal IRA contributions are when one spouse pays contributions in the name of the other, either because they are not working or earn less. Withdrawal rules for spousal IRAs are the same since there is no difference in account type. Remember, your adjusted gross income cannot exceed $218,000 for joint Roth IRA filers.

Understanding Spousal IRAs

Withdrawal Rules for Spousal IRAs

Rollover Options for Spousal IRAs

IRA Rollover Rules and Considerations

Understanding IRA Rollovers

Direct vs Indirect Rollovers

A direct rollover acts like a transfer, but this is done between two types of accounts.  As an example, you can roll over a 401(k) plan to a traditional IRA.  This requires your administrator sending your balance to another qualified retirement account.  

An indirect rollover is more complex.  You will also have more rules to follow when doing an indirect rollover.  You’ll receive a payment for your balance or an amount you decide to request, but this will be without any taxes incurred.  You have 60 days to deposit the funds.

Tax Implications of Rollovers

One-Rollover-Per-Year Rule

Frequently Asked Questions

What are the penalties for withdrawing from an IRA before age 59 1/2? 

A federal penalty tax of 10% is applied to IRA withdrawals made early- on top of regular income tax on the taxable amount.

What are the exceptions to the early withdrawal penalty?

Exceptions apply if the account owner has a total and permanent disability, or if the withdrawal is made after the account owner’s death by the beneficiaries. Up to $10,000 can also be withdrawn early without penalty for a first-time home purchase. Some other exceptions apply for specific educational or health reasons.

How does a Roth IRA differ from a traditional IRA in terms of withdrawal rules?

Withdrawal penalties only apply to earnings from a Roth IRA. Your contributions can always be withdrawn tax-free and without penalty.

What strategies can I use to minimize tax on my IRA withdrawals?

Delaying your retirement, limiting how many distributions you take during the first year, and making qualified charitable donations can help minimize tax exposure on your IRA withdrawals. It also helps to convert to a Roth IRA.

Can I use my IRA money for purposes like education or home purchase without incurring penalties?

In some cases, yes. You can withdraw up to $10,000 as a first-time home buyer without a penalty. Postsecondary education expenses may also qualify as penalty-free withdrawals.

Conclusion

As long as you follow regulations and wait until you are of eligible age, you don’t need to worry too much about IRS withdrawals. You should, however, bear in mind that there is a required minimum distribution once you hit 73.

Understanding withdrawal rules helps you get the best from your IRA and avoid paying more tax than needed. It also keeps you in the good books with the IRS!