Individual retirement accounts (IRAs) can help you save for major expenses in the future, like a house down payment. But you won’t be able to withdraw these funds whenever it suits you; their funds must remain invested until withdrawal time.
Instead, it is your responsibility to abide by certain rules or face penalties. Here are the main ones:
Limitations
As an IRA is intended for long-term retirement savings, it’s best to stick to your plan and use the money only in extreme situations. For instance, if you need the funds before age 59 1/2 and pay taxes and penalties (unless an exception applies).
As an example, your IRA funds may be withdrawn penalty-free before age 59 1/2 if used to buy, build or rebuild a first home; pay unreimbursed medical expenses that exceed 10% of your adjusted gross income; receive unemployment compensation for 12 consecutive weeks or are completely and permanently disabled.
Roth IRAs differ in that withdrawal restrictions don’t come into play until age 59 1/2 or after you die; for more details see our article on inheritable Roth IRAs.
Taxes
Traditional IRA contributions are generally tax-deductible while withdrawals are taxed as ordinary income. With a Roth IRA, on the other hand, contributions incur taxes up front but withdrawals remain tax-free.
If you withdraw before age 59 1/2, an early withdrawal penalty of 10% will apply. There are exceptions; for example if the withdrawal is used to buy, build or rebuild your first home; qualifying higher education expenses of yourself, spouse and/or children can also be covered without penalty; in addition to qualified medical expenses or certain disability insurance premiums that qualify.
If you inherit an IRA, it’s essential that you comply with the IRS required minimum distribution (RMD) rules and seek guidance from an advisor when planning distributions to ensure you don’t move into a higher tax bracket. Furthermore, you have the option of rolling over its assets into an account of your own.
Rollovers
Typically, each 12-month period only allows one rollover from your employer-sponsored retirement plan into either a traditional or Roth IRA – including money from SIMPLE or SEP IRAs – into either type of IRA – from traditional to Roth.
By asking the payer of your distribution to transfer it directly into another eligible retirement account (such as an IRA), direct rollover allows you to bypass the mandatory 20% withholding rule and keep more of your money.
Rolling over distributions from employer-sponsored retirement accounts means transferring their tax-deferred earnings and growth to your own IRA or 401(k). Your new investments could grow tax-free or tax deferred depending on which IRA type you select; however, keep in mind its rules and fees when choosing.
In-Kind Distributions
Some individuals can benefit from in-kind distributions over cash distributions for tax reasons. For example, if you hold company stock in your retirement plan and are over 59 1/2, in-kind distribution allows you to take advantage of any net unrealized appreciation (NUA) that may have accrued.
Your IRA provides another way of taking RMDs: taking them directly. In-kind RMDs reset your cost basis so if you sell any shares with gains over original purchase price, only taxes on that portion are payable.
Your brokerage provides online access for initiating an in-kind transfer, while larger brokerages often charge fees for moving assets between accounts they manage; others don’t charge this service fee at all. When initiating such transactions, the new brokerage needs your most recent account statement in order to complete this type of transfer successfully.
