Withdrawals from an IRA will generally be taxed as ordinary income. But there may be ways to mitigate their tax impact.
Financial professionals can offer guidance that could save money, such as using taxable accounts before taking distributions from tax-deferred ones and making these moves during low income years. Roth accounts, funded with post-tax dollars, may also help reduce your taxable income at retirement.
1. Donate Part of Your IRA to Charity
Individual retirement accounts (IRAs) can be an excellent way to save for the future, but you need to understand their tax rules in order to withdraw money without incurring penalties or fines. Roth conversion ladders could help avoid such penalties altogether.
Taxes will generally apply to traditional and Roth IRA contributions and withdrawals, with Roth IRA contributions and earnings untaxed. If you withdraw funds before age 59 1/2, however, typically an early withdrawal penalty of 10% in addition to income tax will be assessed against them.
Many factors could increase your taxable distribution, such as moving to a state with higher income tax rates or adding a new spouse. Because of these circumstances, it is often wise to avoid withdrawing funds before age 59 1/2 unless an exception applies – consulting with a financial professional is always recommended to make sure you take the best approach for yourself and your situation.
2. Take a Distribution in a Low-Income Year
Withdrawals from traditional and self-employed retirement accounts like SEP-IRAs and SIMPLE IRAs are taxed as ordinary income; any withdrawals prior to reaching the Required Minimum Distribution age (59.5) will incur taxes at your current tax rate plus possibly a 10% penalty tax.
As part of your RMDs, the IRS calculates an annual withdrawal amount by dividing your end-of-year IRA balance by your life expectancy. You can reduce how much of an amount must be withheld each year by taking it during low income years.
If you have enough liquid assets, another way of fulfilling your RMDs without counting against your tax bill may be donating shares from an IRA directly to charity as part of a qualified charitable distribution (QCD) instead. It’s typically best to do this when taking your RMD in that year.
3. Roll Over Your IRA
If you are transitioning from an employer-sponsored plan to an IRA, there are various strategies you can employ to reduce taxes upon distributions. Before making this move, however, consult a financial advisor first.
One option for moving funds between employer-sponsored plans and IRAs is direct rollover, in which your former employer’s plan administrator sends a check directly to your new IRA account provider for the total balance of your IRA account. This method is the safest because it ensures the transfer is complete and compliant with IRS rules; indirect rollovers may work, too, although strict compliance must be observed or you could face an early withdrawal penalty and tax of 10% early withdrawal penalty plus tax. Also keep in mind that IRAs offer unique investment options and services not found with employer-sponsored plans such as penalties-free distributions at age 55 plus creditor protection protection services compared to employer plans offered by employer plans offered by employers such as tax benefits of employers such as employer plans offered by employers such as tax advantages that give employers-sponsored plans such as these offered by providing their plan administrators.
4. Take a Distribution as a Qualified Distribution
A qualified distribution is a withdrawal from an IRA that qualifies for certain tax benefits, and must be made once you reach age 59 1/2 and directly into another qualified retirement account or rollover from an employer plan, except if changing jobs or retiring.
Qualified charitable distributions (QCDs) are an efficient way for IRA owners to give back while fulfilling their required minimum distribution (RMD). Plus, these donations don’t count towards income reporting either!
The IRS penalizes early withdrawals to deter misuse of tax-advantaged retirement accounts and encourage people to save for their golden years. However, these penalties can be avoided under certain conditions, including being permanently disabled, withdrawing funds as beneficiaries or taking COVID-19-related distributions reported ratably over three years. You also can escape this penalty when withdrawing money for purchasing your first home or paying medical insurance premiums while unemployed.
