Individual retirement accounts (IRAs) offer more flexibility than a 401(k) account when it comes to taking withdrawals. If you have a financial emergency, you can withdraw money from your IRA to meet your financial needs. However, when you withdraw funds from an IRA can determine whether or not you will pay a penalty tax.
You can withdraw money from an IRA as often as you can and as much as you can, as long as you are willing to bear the cost of withdrawal. Since you own all the funds in the IRA, you can withdraw the money any time you need it, but there may be income taxes and penalties to consider when you withdraw from an IRA.
IRS Restrictions for IRAs
The IRS requires that IRAs should be held with a trustee or custodian, who can be an investment brokerage firm, bank, or other financial organization. In this case, the custodian only holds the funds on behalf of the customer, but the IRA account holder retains ownership of the funds.
When you use an IRA to save for retirement, the IRS does not restrict how often you can access your IRA funds. You can tap into your IRA whenever the need arises and for any purpose. However, if you withdraw the funds before the required retirement age i.e. age 59 ½, you will owe ordinary income taxes and an additional 10% penalty tax for early withdrawal. However, withdrawals made after age 59 ½ only attract ordinary income taxes.
Early withdrawals from IRA
The contributions made to an IRA are meant for your retirement years, and the IRS rules favor retirement savers who wait until they are age 59 ½ or older to take IRA distributions. The IRS wants to ensure that the retirement money remains in the account until you retire or reach age 59 ½.
If you withdraw funds from your IRA before age 59 ½, the IRS will impose a 10% early withdrawal penalty on the amount withdrawn. You will also owe ordinary income taxes on the distribution. If you are in a high tax bracket, you could lose up to 30% to taxes and penalties.
Roth IRA withdrawals have different tax treatments compared to a traditional IRA. Usually, you won’t pay taxes or penalties when you withdraw Roth IRA contributions. However, you will owe taxes and penalties when you withdraw investment earnings before age 59 ½. Once you reach age 59 ½, you won’t pay taxes or penalties when you withdraw the investment earnings.
How to avoid an early withdrawal penalty on IRA withdrawals
Although the IRA money is meant to be used in retirement, there are certain situations when retirement savers can tap into their IRA before age 59 ½ without paying an early withdrawal penalty.
Some of the expenses that qualify for an exemption from the early withdrawal penalty include home purchase for first-time home buyers, medical payments, permanent disability, IRS levy, and health insurance if you are unemployed.
At the onset of the COVID-19 pandemic, the CARES Act allowed retirement savers to withdraw up to $100,000 from their retirement accounts penalty-free. However, to get this benefit, retirement savers were required to qualify for CARES Act withdrawals. Taxpayers were allowed up to three years to pay taxes on the CARES Act withdrawals.
Even with the early withdrawal penalty exemption, you will still owe ordinary income taxes on all distributions taken from the IRA.
Regular IRA distributions
Once you reach age 59 ½, you can withdraw funds from your IRA without paying a penalty tax. These distributions are considered regular distributions since they are taken after you have attained age 59 ½.
Since an IRA is funded with pre-tax dollars, you will pay taxes on any distributions you take. You must report the distributions taken from the IRA on IRS tax Form 1040. The amount withdrawn from the IRA is considered an income, and it will be added to the taxable income for the year. You will pay income taxes on the amount withdrawn at your tax bracket rate.
Required Minimum Distributions from IRA
The IRS requires that you must start taking the required minimum distributions (RMDs) from an IRA once you reach age 72. These distributions are mandatory, and you must take the distributions regardless of whether you took distributions earlier or not.
If you take less than the required distributions or opt not to take the mandatory distribution, the IRS will impose a 50% penalty tax on the RMDs not taken.
The RMDs are based on your IRA balance and your life expectancy. You can take the distributions annually, or several times during the year, as long as you take the minimum distribution. Generally, you can withdraw more than you are required to take, but you cannot take less than the required distribution.
If you don’t need the mandatory distributions once you are 72, you can opt to rollover the IRA to a Roth IRA. A Roth IRA does not require retirement savers to take RMDs from the account, and you can let the money remain untouched until when you need it. When you rollover from a traditional IRA to a Roth IRA, you will pay taxes on the rollover.
