Putting money away in an individual retirement account (IRA) is a wise decision for those who want to one day step away from the working life. It allows money to grow without the encumbrance of taxes, having been designed as a mechanism for the average person to improve their long-term financial standing. While it might be technically slotted for retirement, it’s still your money. This means that you can technically access it at any time as long as you are willing to accept the tax implications of your decision. With this in mind, here is how you can determine taxes on your IRA distribution. Understanding these rules can help you make the best decision on when to pull money from your account.
How old are you?
The first step in the process is to figure out how many birthday candles you had on your cake this year. IRAs are restricted accounts in some ways. They are mechanisms through which your money can grow without up-front taxation. The government allows this because there is a societal incentive for people to save for retirement. You are essentially receiving a benefit from the government in exchange for your promise to keep the money in your account until you reach something close to retirement age. This means that if you take money out before that time, you’ll have to pay a penalty.
What’s the magic age? It’s 59 and a half. If you’re younger than 59 and a half years and you withdraw money from a traditional IRA, then you will have to pay a penalty on the distribution. That penalty is 10%.
Understanding IRA distributions through an example
Just because you didn’t have to pay income tax on your IRA contributions does not mean you are forever free of tax responsibility. In fact, you have just deferred tax liability until later in life. Often, this works out well, since most people will earn less in their golden years than in their prime. They’ll be taxed on distributions at a lower rate. Still, you will owe income tax on any money you withdraw from your IRA, even if you are over the magic age of 59 and a half.
Imagine, for instance, a woman who is 61 years old. She withdraws $20,000 from her IRA at that point. She would owe income tax on that amount. That income would be taxed as ordinary income, so it would fall into whatever marginal tax bracket she happened to be in depending on her other income.
If she happened to be 58 years old, she would still owe income tax on the money she had withdrawn. She would also owe an extra $2,000 in penalties because she chose to withdraw the money before she reached the magic age.
Understanding Roth IRA distributions
Some people go with a Roth IRA, which allows them to pull money out before the age of retirement. There are penalties associated with some of these distributions, however. For a person under 59 and a half, there is a 10% penalty if the Roth IRA has been open for less than five years. Each of these rules is designed to encourage long-term investment and deter people from taking early distributions.