Your age at the time that you make a taxable withdrawal from your Traditional IRA account can make a big difference in the amount of tax that you will pay. Generally, there are three periods within your lifetime where different tax rules apply:
- Under Age 59 ½—If you withdraw IRA funds before you reach age 59 ½, you will pay tax and a 10% early withdrawal penalty unless you can avoid the penalty through one of the several exceptions provided in the tax law. Note: Some states also have small early withdrawal penalties.
- Age 59 ½ to Age 70 ½—During this period, you can make withdrawals of any amount without penalty. You are only subject to income tax.
- Above Age 70 ½—After reaching age 70 ½, you must begin taking at least the required minimum distributions or face the 50% excess accumulation penalty.
The key to minimizing taxes on IRA distributions is to match withdrawals to tax years, in which case you are in a low-tax bracket or even have a negative taxable income. Take, for example, a year when your income—because of illness, disability, unemployment, or large business losses—is less than your deductions and personal exemptions, which leaves you with a negative taxable income for the year. To the extent that your taxable income is negative, you could make a taxable IRA withdrawal and avoid any tax on the amount withdrawn. In this case, even if you were under age 59 ½, you would only pay the small early withdrawal penalty.
Generally, except as mentioned above, if you are under 59 ½, your IRA funds are not a good source of cash, except in cases of extreme need, simply because of the tax liability and penalties that come from withdrawing these funds early. However, if you have no alternatives, it may be possible to avoid part or all of the penalties by carefully planning the withdrawals so that they qualify for one or more of the early withdrawal penalty exceptions: (1) amounts withdrawn to pay un-reimbursed medical expenses; (2) amounts withdrawn while qualifying as disabled; (3) amounts withdrawn and used to pay for medical insurance while unemployed; (4) amounts used to pay higher education expenses; (5) amounts up to $10,000 for the purchase of a first home; and (6) early retirement amount withdrawn as an retirement annuity. Taxpayers must meet certain criteria to qualify for these exceptions, so be sure to contact this office to make sure that you meet those qualifications before proceeding.
For retired individuals who are receiving Social Security benefits, planning IRA distributions can also be beneficial. Social Security itself is only taxable when half of the taxpayer’s Social Security benefits added to the taxpayer’s other income exceeds $25,000 (or $32,000 for a married couple filing jointly). Once this threshold is reached, every additional dollar of other income will cause 50 to 85 cents of the individual’s Social Security benefits to also become taxable. Therefore, if a taxpayer’s other income is under the threshold, it is generally a good practice to withdraw just enough taxable IRA funds to bring the income up to the threshold amount, even if the funds are not needed in that year. They can be set aside for a future year when they might be used for some unplanned need or large purchase. Retirees with income that already puts them over the Social Security taxable threshold should avoid large, uneven withdrawals that might push them into a larger tax bracket one year and way below that tax bracket change in other years.
Remember: Once a taxpayer reaches age 70 ½, he or she must begin taking distributions equal to or greater than the Required Minimum Distribution, which somewhat limits planning options. If you wish to explore any of these or other tax saving techniques, please contact this office.