You contribute to your retirement accounts to withdraw funds in retirement, right? But there are many rules you must understand before you take those distributions.
Knowing them now may help you determine how best to invest in your retirement and when to withdraw funds to minimize your tax liabilities.
Taxability of Traditional and Roth Distributions
First, you should know that most retirement distributions are taxed in some way unless you invest in a Roth IRA or 401K. Not everyone is eligible for a Roth account, so always discuss it with a professional CPA to be sure.
In general, traditional distributions are tax deductible when you contribute the funds. Still, you make up for it by paying taxes on the withdrawal of your contributions and earnings in retirement. You benefit by paying (hopefully) a lower tax bracket in retirement.
Roth distributions aren’t tax deductible when you contribute, but if you follow all the rules (more on this below), you don’t pay taxes when you withdraw contributions or earnings.
The Roth Rules
To take advantage of the Roth account savings, you must have the account for at least five years before withdrawing funds. Even if you’re over 59 ½, if you haven’t had the account for more than five years, any earnings (not contributions) you withdraw are taxed at your ordinary tax rate.
Early Withdrawal Penalty
No matter your retirement account type, there’s an age limit to withdraw funds. If you withdraw funds before 59 ½, you’ll pay a 10% penalty on the amount withdrawn.
There are some exceptions, such as hardship withdrawals for certain issues, including the death of the account owner, medical issues, or permanent disability, to name a few. The IRS outlines each exception here.
Early Withdrawal of Roth IRA vs. Roth 401K
If you need access to your funds early, you may pay taxes on your Roth retirement funds even though the contributions were after-tax.
If you withdraw from a Roth IRA early, you’ll first withdraw contributions. Then, if the amount you withdraw exceeds your contributions, you’ll pay taxes on the remaining portion at your current tax rate. You’ll also pay a 10% penalty.
If you withdraw from a Roth 401K early, you’ll withdraw a prorated amount of contributions (no tax) and earnings, which you’ll pay tax on at your current tax rate, plus the 10% penalty.
Final Thoughts
Timing your retirement withdrawals carefully is important. Working with a qualified advisor, you can determine which accounts you should withdraw from both before and during retirement.
Ideally, you won’t withdraw funds before age 59 ½, but if you must, you can minimize your tax liabilities by strategically withdrawing funds from Roth and traditional retirement accounts. In retirement, knowing which accounts to withdraw from to maximize your earnings and minimize tax liabilities is key too.
Contact the professionals at Henson & Murtha CPAs today to get a professional opinion on how to best use your retirement funds before and during retirement.