When your retirement accounts are growing, it’s great to see the numbers climb. But when you retire and start taking money out of your IRA and 401k, the taxes you owe can take a surprisingly big chunk out of your total. Hopefully you’re taking advantage of the tax breaks that come with contributing to most retirement accounts, but are you ready for the taxes and penalties that you’ll deal with when you retire?
The general rule for retirement accounts is that you must either pay taxes on the money before you put it into the account, or when the money comes out. Which timing is best for you, and how can you avoid losing too much in the end?
Types of Retirement Accounts
Individual Retirement Accounts (IRAs)
You’re allowed to put up to $5,000 (or $6,000 if you’re 50 or older) into your IRA every year (i.e. see maximum 401k and IRA contribution limits). Even if you have multiple IRAs, you can’t go over that limit for all accounts combined. There are two types of IRAs: traditional and Roth. Depending on which type you use, you’ll face different tax implications for contributions and withdrawals. Once you’re 59 1/2, you can withdraw without penalties, but if you need to access your cash before that age, you’ll owe a 10% penalty fee.
- Traditional IRA. With a traditional IRA, when you deposit money into your account, you’re lowering your taxable income. At the end of the year, you’ll deduct the total amount you contributed, netting you a tax break for the year. Then, when you retire and start withdrawing the money, you’ll pay taxes on that cash like any other income.
- Roth IRA. A Roth IRA is essentially the opposite of a traditional IRA. You won’t get the immediate tax break when you contribute, but when you reach retirement, you don’t have to pay taxes on any of the money you withdraw. You already paid taxes on the original contribution, and any additional earnings are yours tax-free. Also, you can withdraw your contributions to a Roth IRA at any time without paying a tax penalty, though you will have to pay taxes on the interest you’ve accrued.
Most employers will set up a individual 401k plan for you, and they’ll make it easy to use payroll deductions for your contributions. Those contributions reduce your adjusted gross income, lowering your overall tax liability. When you eventually make withdrawals, you’ll have to pay taxes on your original contributions and on the account’s earnings. If you withdraw the money early (before you’re 59 1/2 years old), you’ll owe a penalty of 10% of the amount withdrawn, plus taxes.
Some workplaces are now offering Roth 401k plans, which let you determine what portion of your contributions will be made pre-tax or post-tax, and those contributions will generally follow the same rules as contributions to a traditional (pre-tax) or Roth (post-tax) IRA.
A 403b account basically has the same rules as a 401k and is a common option for government employees and those working for non-profit organizations. In these accounts, you’ll use payroll deductions to make pre-tax contributions and then pay taxes upon withdrawal. Just like with a 401k, you’ll face a 10% penalty for early withdrawal.
A Savings Incentive Match Plan for Employees, or SIMPLE IRA, is an option that many small businesses use because they’re less expensive to maintain. These accounts are similar to traditional IRAs in that you’ll contribute money pre-tax and then pay tax when you withdraw. But if you need to withdraw money early and your account hasn’t been open for more than two years, then your penalty is 25% instead of 10%.
If you run your own business, you’ll look for a low-cost, easy-to-manage option, like a Simplified Employee Pension IRA, or SEP-IRA. A SEP-IRA is an affordable way to set money aside for retirement if you’re self employed or if you run a business with a small group of employees. These accounts follow the same rules and withdrawal penalties as a traditional IRA.
Exemptions to the Withdrawal Penalty
Warnings about withdrawal penalties are all over retirement account paperwork, so the fees will be no surprise. But you can get surprised by some of the things that may force you to tap into your retirement accounts early. Depending on the circumstances, you might be able to avoid the 10% or 25% hit. The rules differ depending on the account type; here, we’ve laid out all of the situations in which you will be exempt from any tax penalties.
IRA/SEP-IRA/SIMPLE IRA Withdrawal Exemptions
- If you have a Roth IRA, you’re in luck – you can withdraw your contributions to a Roth IRA at any time without paying taxes or fees. However, if you want to withdraw earnings in a Roth or other IRA, you may have fees or penalties assessed unless you also fulfill one of the other requirements below.
- Completing a direct rollover to another IRA, transferring some or all of the money from one IRA account to another without really taking possession of the money.
- A lump sum payout from an IRA that you deposit into another IRA within 60 days.
- Permanent or total disability.
- Paying health insurance premiums during unemployment.
- Paying for college expenses for yourself or a dependent (only specifically qualified expenses apply).
- Purchasing a home, if you haven’t owned a home over the past two years, with the limitation of a $10,000 lifetime maximum for this exception.
- Covering medical expenses that exceed 7.5% of your adjusted gross income.
- Levies by the IRS to pay off your tax debts.
401k/403b Withdrawal Exemptions
- Completing a direct rollover to an IRA, or getting a lump sum payout that you deposit into an IRA within 60 days.
- Becoming disabled.
- Passing away before the age of 59 1/2.
- Retiring at age 55 or older.
- Paying for medical expenses that exceed 7.5% of your adjusted gross income.
- Following the rules of a divorce decree or separation agreement (also known as a qualified domestic relations court order).
Substantially Equal Periodic Payments
If you retire early or need to tap your retirement account before the penalty-free age of 59 1/2, one little-known way to avoid incurring penalties is to set up “substantially equal periodic payments.” The IRS lets you give yourself an annual salary, as long as you are spreading the withdrawals over your entire life. Under this arrangement, you’ll withdraw amounts each year that are roughly the same year to year, and the schedule spans the rest of your life expectancy. Each year, the IRS publishes life expectancy tables to determine the number of years you’ll need to cover, and they’ll also help you account for expected continued growth in your account.
Required Minimum Distributions
While drawing from your account too soon can come with penalties, the IRS also has rules that prevent you from taking disbursements too late as well. Required minimum distributions (RMDs) are payments that you must take from your retirement account after a certain age. For almost all accounts, RMDs start during the year when you turn 70 1/2. One exception is a Roth IRA, which doesn’t have any required distribution.
Additionally, if you are still working at 70 1/2, unless you own shares in your company, you can delay RMDs from employer-sponsored accounts like a 401k until the year in which you stop working. But you can’t put off taking RMDs from an IRA.
Remember, the companies that manage retirement send annual reports to the IRS, and if the IRS sees that you’re not taking RMDs, you can face a tax of up to 50% of the amount you should have withdrawn.
The amount of your RMD will depend on your age, marital status, and the total value of all of your retirement accounts. The IRS publishes tables annually that list the required minimums. If you have more than one retirement account, you will need to determine how much you need to take from each account. You may not turn around and deposit the withdrawals into another retirement account, but you can move the funds to an interest-bearing savings account like ING Dirct or Ally Bank.
In the event that you inherit an IRA, 401k, or other retirement account, you’ll have to choose to either withdraw the entire amount within five years of the original owner’s death or you can take required minimum distributions over your entire lifetime. Taking the entire amount will mean a huge tax hit, so many people choose to take RMDs to spread out the tax obligation.
Whether you’ve had your retirement account for one year or thirty, you’re hoping to watch your balance climb – quickly. When you reach your goal, the last thing you want is to realize that your taxes will set you back so far that you have to delay retirement. Making the most of tax-deferred savings is wise, so make sure you stay just as smart about the final tax implications of withdrawals too.
Planning ahead can make tax time a lot less painful when you reach retirement age. Have you started tapping your retirement accounts? How are you planning to reduce your tax burden?
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