Is There a Way to Avoid Tax on IRA Withdrawal?
There are various strategies available to you for avoiding tax on IRA withdrawals, though they require careful thought and planning. Examples include creating a self-directed IRA holding alternative investments or using life insurance to leverage its net after-tax value of your IRA.
Early withdrawals from an IRA or 401(k) usually incur income taxes and a 10% penalty unless an exception applies, but there are legal strategies available that may help minimize penalties.
Contributions
If you are under age 59 1/2 and make an early withdrawal from either your traditional or Roth IRA, taxes and potentially penalties will likely apply unless an exception applies. When reaching age 59 1/2 however, rules change dramatically and withdrawals could become tax free with no income taxes payable or penalties assessed.
Once distributions from both accounts reach that threshold, your regular ordinary income tax rate applies. Depending on your current tax bracket, that could be significantly more than the 15% long-term capital gains tax rate.
One way to sidestep the ordinary income tax rate on IRA distributions when retiring is to withdraw first from your taxable accounts and then proportionally from IRA accounts – especially if your retirement income level will be lower. This strategy works especially well if your expected tax bracket drops after retirement than currently.
One way to reduce income tax when withdrawing IRA withdrawals during retirement is to make donations directly from your IRA to charity. The IRS allows this through Qualified Charitable Distributions – distributions made tax free directly from an IRA account.
Withdrawals
How you withdraw funds from an IRA account determines whether or not you owe income tax. Roth accounts are always tax free because contributions were made after tax dollars; traditional IRAs however are subject to ordinary income taxes on withdrawals with one exception: taking a qualified withdrawal.
Qualified withdrawals include military service, higher education expenses for you and your children and certain medical bills. If you withdraw funds before age 59 1/2, typically there will be a 10% penalty plus regular income tax due on them.
If you want to avoid an early withdrawal penalty, taking distributions during a low-income year might help. Or you could rollover an IRA instead of withdrawing it; this involves getting a check from your employer and depositing it within 60 days into a different account, preventing withholding of 20% to pay income tax.
Rollovers
IRAs enjoy unique tax treatment, but with it comes special obligations. Unwise withdrawals from retirement accounts may incur severe tax implications; being careful about where and what form the money comes out can prevent an IRS audit and a potential disaster from unfolding. A proper rollover solution could save this potentially disastrous scenario from unfolding.
To achieve a true rollover, funds must travel directly from their original account into your IRA. That is why it is vitally important that your new custodian understands the difference between transfer and direct rollover. Any eligible rollover distribution you receive from an employer plan will typically have 20% withheld for federal income taxes; you have 60 days from receiving this distribution to deposit any outstanding 20% into your IRA, otherwise taxes plus possibly penalties could become due. However, under special circumstances the IRS may waive this deadline, although that rarely happens.
Taxes
The IRS typically won’t seize your IRA or 401(k) accounts to cover unpaid federal taxes; if it happens anyway, however, then a 10% penalty must be paid and any of your IRA funds that were used to cover such debt must also pay income tax on that portion of its account that went toward paying said debt.
If your out-of-pocket medical expenses, not covered by insurance and that don’t exceed 7.5% of your adjusted gross income (AGI), exceed $7500, then penalty-free withdrawals from an IRA could help pay them. They could also help cover a first home purchase, disability payments or equal periodic payments throughout your life expectancy.
Traditional IRA and 401(k) withdrawals before age 59.5 typically incur an early withdrawal penalty of 10% in addition to income tax; unless an exception applies. There are ways you can minimize this tax liability, including converting from traditional to Roth IRA or donating securities from an IRA directly to charity.
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