How Can I Avoid Paying Taxes on an Early IRA Withdrawal?
Individual retirement accounts (IRAs) are designed to help individuals save for the future; however, withdrawing money before age 59 1/2 typically incurs a 10% penalty and income taxes on top of any additional withdrawal penalties. There are however exceptions which allow individuals to access funds held in an IRA without incurring penalties or income tax dues.
Owners of an Individual Retirement Account (IRA) can withdraw distributions without incurring a penalty in certain instances, including uninsured medical costs and first-time home purchases.
Taxes on IRA withdrawals
Once withdrawn from traditional IRAs and employer-sponsored retirement accounts such as 401(k) plans, withdrawals will generally be taxed at least partially. How much tax you owe depends on factors like account type, contribution history and age. Furthermore, your tax rate will depend on both income level and filing status.
An IRA withdrawal adds the taxable portion to your taxable income for the year, potentially increasing your tax bill if you are now in a higher tax bracket than when making contributions.
Withdrawals from traditional IRAs typically attract income taxes and the 10% early withdrawal penalty if taken before age 59 1/2, though there may be exceptions such as using them to cover certain medical expenses (so long as their total medical costs for the year do not exceed your withdrawals) or to buy, build, or rebuild a first home.
Many expenses that meet IRS rules can be paid from retirement account funds without incurring taxes or penalties, including uninsured medical expenses, adoption costs for children adopted as foster care or first-time home purchase expenses. Furthermore, taxpayers over age 70 1/2 can make donations directly to qualified charities through Qualified Charitable Distributions (QCDs).
One solution is the 60-day IRA rollover rule, which allows you to withdraw funds without incurring taxes or penalties, provided they’re returned within 60 days to their original IRA account. But this solution should only be considered a temporary solution; you should ensure you don’t miss this window!
An alternative approach would be to use your IRA withdrawals to meet the annual required minimum distribution (RMD), thus lowering taxable income and potentially saving on Social Security and Medicare taxes.
Penalties for early withdrawals
Ideal retirement savings should remain intact until it was time for you to retire, but unexpected expenses sometimes necessitate withdrawing money early from an IRA. Without meeting one of the exceptions, the IRS charges a 10% early withdrawal penalty; Roth IRA rules offer greater flexibility; withdrawals (not earnings) can be made without incurring penalties.
The IRS allows penalty-free hardship withdrawals to cover qualified medical expenses that exceed 7.5% of your adjusted gross income (AGI). New parents can withdraw up to $10,000 from an IRA account as birth and adoption expenses; just file Form 5329 and include this withdrawal in your taxable income for accounting purposes. It’s wise to carefully consider your options before taking a distribution in order to avoid incurring penalties for withdrawals.
There may be various strategies available to you for avoiding taxes on IRA withdrawals. To maximize your options, consult with a financial advisor – SmartAsset’s free advisor matching tool can connect you with professionals in your area.
The IRS allows IRA owners to take penalty-free distributions for certain expenses, including health insurance premiums. You must have been unemployed for 12 consecutive weeks prior to receiving unemployment compensation in either year; distributions also can be taken tax free for college expenses for yourself or spouse/children and medical costs exceeding 7.5% of adjusted gross income.
If you are over 70 1/2, required minimum distributions (RMDs) must begin from your traditional IRA. An RMD can be calculated by dividing the cumulative nondeductible contributions made across all your IRAs by life expectancy; or using another formula which takes into account business income.