Everything Advisors Need to Know About IRA Distributions and Taxes

We all understand the importance of saving for retirement. But sometimes, life happens, and we must dig into our retirement accounts before we necessarily planned to. In addition to early distributions like these, there are normal and required ones, too—these different distribution types and associated tax liabilities are all affected by things like age and the type of retirement savings account you have in the first place. Although there is certainly a wide variety of retirement plan options, we will be focusing solely on the distributions of traditional IRAs and Roth IRAs and how they relate to taxes.

There are three types of distributions from IRAs: “early” or “premature” distributions, normal distributions, and required minimum distributions (RMDs). Below we will go over more details about each of these distribution types, but first, we will have to understand how your age affects these distributions. Generally, if a withdrawal is made before age 59 ½, the distribution will be considered “early,” and you will likely have to pay an additional 10% tax on these distributions. From ages 59 ½ to 72, you are free to make withdrawals from your accounts without penalties or restrictions. Then, from age 72 on, you will be penalized if you do not withdraw from your account.

Early Distributions

Let’s dive into the “early” distributions. As mentioned above, distributions from IRAs before you turn 59 ½ will generally result in a 10% additional tax. This additional tax is put in place to encourage account owners to accumulate wealth for retirement rather than access it freely before they retire. Although it usually is in your best interest to leave the money alone, the IRS also encourages certain behaviors and actions, such as education and purchasing a home; hence there are few exceptions to this additional tax. Here are some of those exceptions:

Age

Once you turn 59 ½, your distributions will not be subject to the additional 10% tax, and you are free to make withdrawals without penalties or restrictions.

Disability

If the account owner becomes totally and permanently disabled, the additional 10% tax will not apply to their distributions. The IRS requires proof of disability to avoid this penalty. In this case, the IRS defines disability as an “inability to perform substantial gainful activity (more than an insignificant amount of work) because of an identifiable physical or mental impairment that is expected to be of ‘long-continued and indefinite duration.’”

Death

If the account owner passes away, the beneficiaries are generally allowed to make withdrawals from the account without the additional 10% tax, unless the beneficiary is the surviving spouse and the spouse decides to treat the account as their own. When this happens, all of the original account owner rules apply to the surviving spouse. They can make contributions to the account, take distributions (their age will determine the type of distribution), and name beneficiaries of their own.

Higher Education Expenses

The IRS encourages higher education. Hence all the tax credits, deductions, and tax benefitted savings plans. This is also the case when it comes to retirement funds. Early distributions from your IRA accounts will not be subject to the additional tax if the distribution is used for tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution. This is true only if the amount withdrawn isn’t more than the qualified expenses. In addition, the distribution doesn’t have to be for the account owner; it can be used towards their spouse, children, or grandchildren. However, it is important to note that an IRA distribution used to pay off student loans will be subject to the additional 10% tax.

First-Time Homebuyers

The IRS also encourages the purchase or renovation of homes. For a first-time homebuyer, IRA account owners are allowed to withdraw up to $10,000 for use toward buying or building their first home. The IRS considers you a “first-time homebuyer” if you haven’t owned a home at any point during the last two years. For you to qualify for this exception, the money must be used within 120 days after the withdrawal. If you and your spouse both have IRAs, you each can withdraw $10,000. Just like the education expenses discussed above, this withdrawal can be used personally or for your spouse, children, grandchildren, or parents to buy a house.

Unreimbursed Medical Expenses

If you have unreimbursed medical expenses—expenses not covered by your insurance—you may be able to withdraw funds from your retirement account if they meet a couple of requirements. As of 2021, if there are unreimbursed expenses over 10% of your Adjusted Gross Income (AGI), the amount over 10% is not subject to the additional tax.

Military

The additional 10% tax on distributions does not apply to a military reservist that has been called to active duty for at least 179 days or an indefinite period. The distribution must be during the period of active duty. Additionally, certain rules allow the reservists to repay the distribution once their active duty ends, even if the contributions are in excess of the annual limits.

Rollovers

A rollover from one IRA to another IRA generally will avoid the additional tax, but there are a couple of requirements that need to be met. There are three types of rollovers that will allow you to avoid the 10% additional tax: direct rollover, trustee-to-trustee transfer, and a 60-day rollover. To avoid withholding and tax entirely, direct rollovers and trustee-to-trustee rollovers are the best options.

Direct Rollover: With this type of rollover, you personally don’t receive the distribution. Your plan administrator will make a direct payment from one IRA to another without any taxes being withheld from the transfer amount.

Trustee-to-trustee: With this type of rollover, you also don’t receive the distributions. The bank or institution holding your IRA makes the payment directly from one IRA to another IRA without any taxes being withheld.

60-day Rollover: With this type of rollover, the payment is made directly to you, and you then have 60 days to deposit all, or a portion, of the distribution into an IRA. Taxes will be withheld from this distribution, and you will have to use other funds to roll the full amount to the other IRA. If you don’t roll the full amount distributed back into an IRA, you will be subject to the additional 10% tax on the amount not redeposited.

As we all know, there is a key difference between Roth IRAs and traditional IRAs when it comes to taxes. When contributing to a Roth IRA, you are investing after-tax dollars into the account. As for traditional IRA contributions, you are deferring that tax to a later date. This difference plays a major role when it comes to distributions. All the exceptions noted above are exceptions to the additional 10% tax—not exceptions to income tax. For a Roth IRA, the distribution of principal (amount contributed) will be income-tax-free, regardless of any exception that may apply. This holds true only if you held the Roth account for at least five years.

These are the most common exceptions to the additional 10% tax on distributions from both traditional and Roth IRAs. If you don’t meet all the requirements for any of the exceptions, the amount withdrawn will still be subject to the additional tax, as well as income tax (for traditional IRAs).

Normal Distributions

Now that we have gone over early distributions let’s talk about normal distributions and when you can start making withdrawals without the additional tax. Once you turn 59 ½, there is a period when you can make withdrawals from your retirement account without incurring any penalties or having restrictions. This only lasts for so long until you must make withdrawals.

During this period, you will start to notice the differences between traditional and Roth IRAs, which will determine the taxability of your distributions. If you are working with a traditional IRA in retirement, you will have to pay taxes on the withdrawal at your current tax rate. This is beneficial if you were in a higher tax bracket when you made contributions and chose to defer the tax when you are in retirement at (hopefully) a lower tax bracket. On the other hand, if you are working with a Roth IRA, your distributions will not be taxed. This is because you contributed after-tax dollars earlier on when you were in a (hopefully) lower tax bracket.

Required Minimum Distributions (RMDs)

Once you turn 72 (70 ½ if you turned this age before January 2020), and you have a traditional IRA, you must start making annual RMDs. Required Minimum Distributions are the minimum amount you must withdraw from your IRA each year. RMDs are designed to prevent your retirement fund from becoming solely an inheritance for your beneficiaries.

Calculating the RMDs and calculating the penalty if the RMDs were not made during the year isn’t overly complicated but is still very important to understand because the penalties can be significant. To calculate the RMD for the current year, you will need the balance of your IRA on December 31^st of the previous year. This figure will be divided by the Uniform Lifetime table provided by the IRS. This will then be done for each account you own each year. If you do not take a large enough distribution throughout the year, you will be assessed a penalty of 50% of the amount not distributed. For example, if your RMD for the current year was $25,000, and you only took out $20,000 in the year, you will be subject to an excise tax of $2,500.

A solution to avoid RMDs is to roll over or convert your traditional IRA into a Roth IRA. Roth IRAs have no RMDs for the original owners throughout their lifetime. Unfortunately, though, if you convert your traditional IRA over to a Roth IRA, you will owe income tax on the amount converted.

Retirement accounts can be finicky—it is essential to understand the differences between distributions and whether or not it is worth digging into your life savings, and if so, how best to go about it. Tax planning can be very beneficial and worthwhile when it comes to IRA distributions, especially when dealing with rollovers and conversions. If you have any lingering questions about specific scenarios, the experts at XY Tax Solutions are in your corner to help you navigate all things retirement—and then some.

About the Author

XYTS Tax Specialist Blake Mattfeldt is a recent graduate of the Master of Professional Accountancy program at Montana State University. He has a bachelor’s degree in business with a concentration in finance and accounting. In addition to his experience with the Volunteer Income Tax Assistance program while at Montana State, he worked as a tax intern for Rudd and Company.