Tax Avoidance Strategies For IRA Withdrawals
Savings made using pre-tax dollars typically go into an IRA account and withdrawals prior to age 59 1/2 may incur income taxes and an additional 10% penalty tax, though there are ways you may be able to bypass them altogether.
One strategy to leverage IRA funds with life insurance can be seen here. Here’s how it works.
Taxes on IRA withdrawals
Tax treatment of IRA withdrawals varies by account type; traditional IRAs are funded with pretax dollars but distributions will be taxed as ordinary income in retirement, while Roth IRAs use after-tax dollars but withdrawals remain tax-free.
However, the IRS mandates that you begin taking required minimum distributions (RMDs) once you reach age 72. If you fail to do so and incur a penalty fee. Furthermore, any amounts taken must also be reported on your taxes.
There are some exceptions to the 10% early withdrawal penalty on traditional IRAs, such as using funds for first home purchase or paying medical or disability expenses. Speak with your financial or tax advisor about these or other exceptions from this rule. When making withdrawals from nonqualified IRAs, Form 5329 must be filed to pay an extra 10% tax or claim an exception; failing to do so could incur an excise tax from the IRS.
Qualified Charitable Distributions
At 70 1/2 and older, IRA owners can direct up to $100,000 annually in distributions from their IRA to charities without including them as taxable income. The check must be payable directly to the charity without going through intermediary organizations such as private foundations or donor-advised funds with quid pro quo rewards such as chicken dinners. Using this strategy may help avoid higher tax brackets while protecting personal exemptions under Pease limitations and minimizing deduction reductions under its restrictions.
Donors should consider pairing their RMDs with QCDs to maximize the benefits of this strategy and avoid accidentally incurring tax penalties by failing to take their RMD on time. QCDs must come from traditional or Roth IRAs only; distributions from Keoghs, 403(b), SIMPLE IRAs or SEP IRAs don’t qualify.
When leaving an old company retirement plan or switching jobs, one way of avoiding a 10 percent penalty may be rolling over distributions into an IRA. Each brokerage and robo-advisor has their own process for carrying out rollovers; make sure you contact each one so you understand their rules.
If you deposit the check into an IRA within 60 days, any tax may not apply on its amount. But if it remains in your hands after being distributed and later rollover into another retirement account via indirect rollover, all of it becomes taxable (unless there are exceptions available to you).
Each 12-month period allows only one rollover of your IRA assets; each withdrawal includes a pro rata share of basis and taxability from all Traditional, SEP, and SIMPLE IRA balances combined. If you fail to report it on your return, an amended return must be filed to reflect it.
Roth IRAs offer original account owners greater freedom when it comes to earning income tax-free until death; however, nonspousal heirs will need to withdraw at regular intervals or face a 10% early distribution penalty.
If your tax bracket has dropped lower than you anticipate it will in the future, converting some traditional IRA funds to Roth accounts may be worthwhile – providing that any taxes due are paid from outside sources rather than through your IRA itself. However, this strategy only works if the funds invested will cover future taxes owed without penalty from being depleted from an IRA account.
Before making any financial decisions, always consult a qualified financial professional. Our SmartVestor program can connect you with one of RamseyTrusted’s investing experts who can guide your journey.