If you have a tax-deferred Traditional IRA, sooner or later you're going to have to take money out. It's one of the conditions you agree to in exchange for the benefit of tax-deferred earnings.
When Congress authorized IRAs, it set two withdrawal dates:
- You have to be 59 1/2 to start withdrawing without paying a penalty, although there are some exceptions
- You have to begin withdrawals by April 1 of the year following the year you turn 70 1/2
Those half-year ages may seem an odd choice. Ever wonder where they came from? Insurance company actuarial tables consider you 60 when you reach 59 1/2, and still 70 until you turn 70 1/2.
What you have to take
Of course, just because you're eligible to withdraw at 59 1/2 doesn't mean you must. You can wait until you want to add a source of income to your retirement budget, or you can use some of the money at any point for a particular purpose.
Beginning the year you reach 70 1/2, you must take at least the required minimum distribution (RMD). You find the RMD amount by dividing the value of your account at the end of the previous December by a divisor linked to your age. Your IRA provider will typically provide this number for you. The divisor gets smaller every year. That means the percentage of the amount you have to withdraw from year to year will increase.
Everyone of the same age divides his or her account value by the same number, with one exception. If you name your spouse as beneficiary, and he or she is more than ten years younger than you are, you can use a different table, which uses a longer life expectancy and requires a smaller annual withdrawal.
Tables providing the divisors for each age are available in IRS Publication 590, "Individual Retirement Arrangements."
If you don't withdraw, or if you take less than you should, you may be vulnerable to a 50% tax penalty on the amount you should have taken but didn't. One way some investors get caught in this trap is by assuming if they simply withdraw their earnings for the year they'll meet their obligation. That might be true in some cases, but there is no guarantee.
The tax bite
The tax you owe on earnings you withdraw from your tax-deferred IRA, and on your contributions if you deducted them, is figured at the same tax rate that you pay on your ordinary income. In the case of earnings, everything that was added to your account, including qualified dividends and long-term capital gains, is taxed at the same rate. The lower long-term capital gains rate that applies to these earnings in taxable accounts does not apply to IRA withdrawals.
That's a reason why you might consider making investments that you expect to grow in value, such as certain individual stocks and mutual funds, in regular taxable accounts. You don't owe tax on any increase in value until you sell, and if you've owned them more than a year, you owe tax at the lower capital gains rate when you do. If your taxable investments are worth less when you sell them than they were when you bought them, you can use the capital loss to reduce other capital gains and even some ordinary income. That's not possible if your IRA investments lose value.
The other thing to think about as you reach 70 is whether to postpone taking your first RMD until April 1 of the following year. There may be arguments for doing that. But there's also a potential drawback. It's that you'll have to take two RMDs the same year, one for the year you turn 70 1/2 and one for the year you're 71. The double RMD could boost you into a higher tax bracket.
Taking it early
You have the right to take advantage of the exceptions to the rule against early withdrawals from your IRA. There's no 10% tax penalty if you withdraw from an IRA to pay your higher education expenses, put money down on your first home, pay medical bills, or support your family while you're disabled. But you will owe taxes at your regular rate.
Another way to access money in your IRA without a penalty before you're 59 1/2 is to annuitize your distribution. This means you set up a withdrawal plan that pays you a fixed amount of your IRA balance each year, based on your life expectancy. The plan must cover at least five years or all the years left until you reach 59 1/2, whichever is longer.
Before you decide on annuitization, though, you should consider that by tapping your retirement savings early, you may have less money in your later retirement than you need to live comfortably.