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Tax Implications of Retirement Accounts – IRA & 401k Distributions & Withdrawals

By Kira Botkin

seniors retirement moneyWhen 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. Determining which is better for your situation or what to expect with existing accounts begins with an understanding of the tax implications of various retirement accounts.

Types of Retirement Accounts

Individual Retirement Accounts (IRAs)

You’re allowed to put up to $5,500 (or $6,500 if you’re 50 or older) into your traditional or Roth IRA for 2103 and 2014 (i.e. see maximum 401k and IRA contribution limits) if you meet eligibility requirements. 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.

  • Traditional IRA. You can deduct the total amount you contribute to a traditional IRA, netting you a tax break for the year. Funds within the account will grow on a tax-deferred basis – meaning, you don’t need to pay capital gains tax on the growth. However, when you start making withdrawals in retirement, you’ll pay income tax on the total amount withdrawn. Most withdrawals made prior to turning 59 1/2 will be taxed and penalized a 10% early withdrawal penalty.
  • Roth IRA. A Roth IRA is essentially the opposite of a traditional IRA. You won’t get the immediate tax break when you contribute  (you can’t deduct contributions), but when you reach retirement, withdrawals are tax-free. Funds also grow on a tax-free basis while in the account (no capital gains). You can withdraw your contributions to a Roth IRA at any time without paying a tax penalty. However, you generally will have to pay tax and a 10% penalty on earnings withdrawn before you turn 59 1/2.

There are a few exceptions to the early withdrawal penalty for Roth and Traditional IRAs (see below).

401k

Many employers set up a 401k plan for their employees, and make it easy to use payroll deductions for employee contributions. Contributions you make into a 401k reduce your adjusted gross income, lowering your overall tax liability. Employers often also provide a match up to a certain percentage of your salary. The maximum annual employee contribution is $17,500 (for 2013 and 2014). Some employees 50 or older may be able to make an additional annual “catch-up” contribution up to $5,500. 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 generally follow the same rules as contributions to a traditional (pre-tax) or Roth (post-tax) IRA.

403b

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 (the maximum annual contribution is also $17,500 for 2013 and 2014). In these accounts, you use payroll deductions to make pre-tax contributions and then pay taxes upon withdrawal. Just like with a 401k, you face a 10% penalty for early withdrawal.

SIMPLE IRA

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 401ks in that you contribute money pre-tax and then pay tax when you withdraw. Employees are allowed to contribute up to $12,000 annually for 2013 and 2014, and employers are generally required to match each dollar of an employee’s contribution up to 3% of salary. But if you need to withdraw money early and your account hasn’t been open for more than two years, your penalty is 25% instead of 10% (in addition to income tax on the withdrawal amount).

SEP-IRA

SEP-IRA is a low-cost, easy to manage way to set money aside for retirement if you’re self employed or run a business with a small group of employees. These accounts follow similar rules and withdrawal penalties as a traditional IRA. However, as an employer, you’re able to contribute up to 25% of your income (or your employee’s income) to a SEP – the dollar amount cannot exceed $51,000 for 2013 ($52,000 for 2014).

Exemptions to the Withdrawal Penalty

Warnings about withdrawal penalties are all over retirement account paperwork, so the fees should be no surprise. Fortunately, however, there are a few exceptions that allow you to avoid the 10% (or in some cases 25%) penalty hit. The rules differ depending on the account type. What follows are situations in which you could 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 penalty fees. However, if you want to withdraw earnings from a Roth (you’ve already withdrawn the total contributions amount) or make withdrawals from a traditional type IRA, you’ll likely pay a penalty unless you also meet one of the conditions below.

  • IRA Rollover. You won’t be liable for taxes or penalties in completing a direct rollover to another IRA – transferring some or all of the money from one IRA account to another without taking possession of the money.
  • Payout and Deposit. A lump sum payout from an IRA that you deposit into another IRA within 60 days won’t result in penalties or taxes.
  • Disability.  Withdrawals made if you’re permanently or totally disabled won’t result in penalties.
  • Health Premiums. Paying health insurance premiums with withdrawals during unemployment won’t result in penalties.
  • Specified College Expenses. Paying for college expenses for yourself or a dependent (only qualified expenses are eligible) with withdrawals may not result in penalties.
  • New Home Purchase. You won’t be penalized if you use up to $10,000 to purchase a home, if you haven’t owned a home over the past two years. There is a $10,000 lifetime maximum for this exception.
  • Specified Medical Expenses. Using a distribution to cover medical expenses that exceed 10% of your adjusted gross income (7.5% if you or your spouse were born before January 2, 1949) won’t trigger the penalty.
  • IRS Levies. Funds withdrawn to pay levies by the IRS to pay off your tax debts won’t be penalized.

401k/403b Withdrawal Exemptions

If you want to withdraw money from a 401k or 403b without penalty, determine whether you meet any of the following exemptions:

  • IRA Rollover or Deposit. A direct rollover to an IRA, or a lump sum payout that you deposit into an IRA within 60 days won’t be penalized or taxed.
  • Disability. Withdrawals made if you’re disabled won’t be penalized.
  • Death. Amounts withdrawn by your beneficiary or estate after your death won’t be assessed a penalty.
  • Retirement. Retiring at age 55 or older and withdrawing funds won’t trigger the penalty.
  • Specified Medical Expenses. Using withdrawals to pay for medical expenses that exceed 10% (7.5% if you or your spouse was born before January 2, 1949) of your adjusted gross income won’t result in a penalty.
  • Divorce. Withdrawals made following the rules of a divorce decree or separation agreement (also known as a qualified domestic relations court order) won’t be penalized.

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, so to speak, without penalty. However, withdrawals must be spread over your entire life (the annual amount is determined by an actuarial formula). Under this arrangement, you withdraw amounts each year that are roughly the same, and the schedule spans your life expectancy. Each year, the IRS publishes life expectancy tables to determine the number of years you’ll need to cover. The IRS also helps you account for continued growth or decline (from investments) in your account.

Required Minimum Distributions

While drawing from your account too soon can result in penalties, the IRS also has rules that prevent you from taking distributions too late as well. Required minimum distributions (RMDs) are withdrawals you must make the year you turn 70 1/2. One exception is a Roth IRA, which doesn’t have RMDs.

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 such as a 401k until the year in which you retire. But you can’t put off taking RMDs from an IRA. In fact, the companies that manage retirement accounts send annual reports to the IRS; if the IRS sees that you’re not taking RMDs, you can face a tax of up to 50% on 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 need to determine how much you have 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 Direct or Ally Bank.

In the event that you inherit an IRA, 401k, or other retirement account from someone who was not your spouse, you can 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 means a huge tax hit, so many people choose to take RMDs to spread out the tax burden. (When a spouse inherits, he or she can often take ownership of the account and follows different rules.)

Final Word

It’s important to understand the tax implications of your accounts so that you know how much money you’ll actually have available to you when you need it. Many people focus on the account amount instead of the amount they’ll see after taxes. But the last thing you want is to realize just before retirement that taxes will set you back such that you’ll have to delay it. If you aren’t already, consider investing in Roth accounts to make tax time a lot less painful when you reach retirement age or need to withdraw funds in an emergency.

Have you started tapping your retirement accounts? How are you planning to reduce your tax burden?

Kira Botkin
Kira is a longtime blogger and serial entrepreneur who enjoys gardening, garage sales, and finding stray animals. She lives in Columbus, Ohio, where football is a distinct season, and by day runs a research study for people with multiple sclerosis. She hopes that the MoneyCrashers team can help you achieve your goals and live a great life.

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  • Richard81

    Good review. Start a Roth IRA early. there is a 5-year restriction on withdrawals from a Roth IRA. The 5-year starts with the opening of the first IRA.

    Another point I’ve not seen mentioned in any of these financial explanation articles is the RMD, the required minimum distribution that starts at age 70 1/2, is taxable. They tell you that. What they don’t tell you is that the RMD is counted as income for the purpose of calculating how much of your Social Security is taxable. In other words, a double tax hit.

    So, maximize the employer match on a 401k contribtion, and secondly, consider strongly, paying the tax and saving into a Roth IRA if possible. Consider whether doing so would raise the income into a higher tax bracket.

    This is not a one-size-fits-all situation, but be aware that the RMD will likely affect how much of the Social Security will be taxed.

    Richard

  • Kira

    Thanks for the info Richard, I am actually working on a post about RMDs and I will make sure to include that!

  • Soapy Sudbury

    I am 72 and I had to take a minimum withdrawal for 2011 on my two Traditional IRA’s. This year I had enough income from my work in real estate sales to contribute to an IRA. Can I make a deposit to an IRA from which I am already taking the RMD?

    • Kira Botkin

      Yes, you can do that. It’ll just raise next year’s RMD amount.

  • Soapy Sudbury

    Thanks

  • rajeev ranjan

    Thank you for the information you have shared here, I was looking for the information.

  • http://www.401kgps.com/tax-implications.aspx 401k Tax Implications

    Thank you for sharing this important information with us. I was looking for the information about 401k tax implications.

  • Debi

    Can I take out my IRA for a home, I havent owned a home since I was in my 20’s and now I’m 50.
    Will there be penalties or not?

  • Franny-Fried

    I am currently 58 years of age (December 16th). I began receiving monthly distributions out of my IRA under the 72T distribution plan January 2011 when I was 57. I have in mind to pay my mortgage off by requesting the necessary $$$ from my IRA. I know that will call for a 10% penalty in addition to the required taxes . . . I hate that fact BUT if that is the rule then it is what it is. I would try to off-set the penalty and the taxes and request that the funds to pay the penalty and taxes be withheld up front.

    Can I start a NEW 72T plan receiving monthly distributions b/c the initial plan would terminate once I get the above funds to pay off my mortgage(s)?

    • Kira Botkin

      Well, personally I might wait until I was 59 1/2 to withdraw the money in order to avoid the penalty, but it depends on whether paying it off now is important enough to incur that fee. However, the rules for 72(t) payments can vary somewhat between servicers, so I would get confirmation from your servicer that the plan would terminate if you withdrew a lump sum. But you should be able to continue getting those regular distributions as long as you like.

  • Needhelp

    What are the tax implications if I closed out an old 401k account to pay off debt?

    • Kira Botkin

      Doesn’t matter why you did it, if it isn’t one of the reasons listed in the 401k/403b Withdrawal Exemptions list above, and you are under 59 1/2, you’re going to pay a 10% penalty and also add it to your taxable income for the year and pay income tax on it. If you’re over 59 1/2, you’ll pay income tax on it.

  • leel3333

    Hello, My mom had to move her traditional IRA into a trust fund due to my dad going into a nursing home (advice from an elderly care attorney) but after about 4 months mom brought dad back home (so the 60 days was past). She has started taking care of him at home – but he is totally disabled – cannot walk anymore – bedridden and she uses a hoyer lift to transfer him to a scooter. She had to get some work done on her home flooring and ramps to work with scooter chair. The taxes they will owe in April will be on about a $93,000 IRA withdrawal. Is there anything she can do to reduce her tax burden – including doing more modifications on their home – helping grandchildren through college – etc… – rather than giving it all away in taxes? Thanks, Leslie

  • Poochv

    At what age must I start withdrawing from my 403b ? What’s the minimum amount I have to withdraw.

  • Brannon Acton

    Can i put money in a ira for a tax break after retired on disibilty.

  • Chris Brown

    If I withdraw money from retirement account and Pay it Back, will I still have to Pay the 10 percent tax penalty on taxable income for that year? And when Paid Back, can I count it as a Deduction for the year Paid back??

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