Taking a distribution from an IRA
E*TRADE from Morgan Stanley02/28/19
If you've faced a job loss, recently retired, or just have sudden expenses, at some point you may be thinking about tapping into your retirement assets. Fortunately, money can be withdrawn from an IRA at any time, for any reason (unlike withdrawals from employer-sponsored qualified plans). However, the regulations surrounding retirement distributions can be complicated. For example, there are rules that dictate the timing of distributions, which distributions are taxed, and which ones are subject to a tax penalty. To make the process a little clearer, consider the basic rules surrounding Traditional and Roth IRA distributions.
Traditional IRA distributions
Typically, withdrawals from Traditional or Rollover IRAs are taxed as ordinary income if the IRA is funded solely with deductible contributions. If contributions weren’t deducted, then a portion of the withdrawal is taxable. To figure the taxable portion, first, find the combined value of all Traditional IRAs (including SEP and SIMPLE IRAs). Then determine how much, or what percentage, of the total value represents non-deductible contributions made to the IRAs. Finally, multiply this percentage by the withdrawal amount. This will determine the non-taxable portion. The remaining amount represents the taxable portion.
In addition to taxes, if under age 59 ½, keep in mind that the IRS also imposes a 10% early withdrawal penalty tax on distributions. This penalty tax may not apply if one of the following exceptions applies:
- Substantially equal periodic payments: Under one of the exceptions in Section 72(t) of the IRS Code, an IRA account holder may escape the 10% tax penalty by withdrawing substantially equal periodic payments determined in accordance with IRS rules. In general, the withdrawal amounts are calculated based on the IRA’s prior year end balance and one of three methods: life expectancy, a fixed amortization schedule, or a fixed annuitization schedule. In addition, these payments must be taken at scheduled intervals. For example, an account holder can elect to take distributions monthly, quarterly, or annually. The amount of these scheduled withdrawals must continue for the longer of five years or until age 59 ½, whichever is longer. These payments cannot be modified, except in instances related to death or disability. Examples of prohibited modifications include taking more or less than the fixed payment amount, taking a payment more frequently than the schedule calls for, or adding funds to the account balance other than investment gains. However, the IRS does allow a one-time switch from an amortization or annuitization schedule to the life expectancy method. If there is a change in the payment schedule or amount, a 10% early withdrawal tax penalty, plus interest, will apply retroactively – all the way back to the first distribution taken under the 72(t) guidelines. Learn more about 72(t) with our 72(t) Factsheet.
- Death: When an IRA owner passes away, the retirement assets pass on to the named beneficiary. Although inherited IRA distributions are taxable as ordinary income to the beneficiary, a 10% early distribution tax penalty will not apply.
- Qualifying disability: A penalty tax-free distribution may be taken due to disability if the IRA owner is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.
- Qualified first-time home purchase: A penalty tax-free distribution up to $10,000 may be taken to buy, build or rebuild a first home. To qualify as a first-time homebuyer, the account holder needs to have had no ownership interest in a principal residence for the last 2 years. A distribution for a first time home purchase may also be taken that benefits a spouse, children, or grandchildren.
- Qualified higher education expenses: A penalty tax-free distribution may be taken to cover qualified higher education expenses, including fees, tuition, books, supplies. Room and board expenses also qualify if the individual is at least a half-time student. The education expenses must have been incurred by the account holder, a spouse, children or grandchildren.
- Other exceptions: Distributions made to pay unreimbursed medical expenses that exceed the adjusted gross income (AGI) threshold for claiming a medical expense deduction. The threshold amount is 7.5% of AGI. In addition, distributions to pay for health insurance if the account holder received unemployment benefits if certain conditions are met, and qualified reservist distributions are all exempt from the 10% penalty tax.
Required minimum distributions
While an account holder can always withdraw as much as they need from their IRA, they are required to begin withdrawing a minimum amount from Traditional and Rollover IRAs at RMD Age, which is age 70½ for individuals born before July 1, 1949; age 72 for individuals born after June 30, 1949, but before 1951; age 73 for indivudals born after 1950, but before 1960; or age 75 for all other individuals (note, there appears to be a drafting error in the statutory language, making it unclear when age 75 starts to apply in lieu of age 73, but it appears it was intended to apply to individuals born after 1959). This amount is called a Required Minimum Distribution or RMD. The amount that needs to be withdrawn is based on the prior year end balance of the account, divided by a life expectancy factor derived from an IRS uniform table. If the account holder has a spouse that is more than 10 years younger, and is the sole beneficiary of their IRA, the RMD can be based on a joint life expectancy table instead of the uniform lifetime table. This results in a lesser RMD amount. Also, remember, RMDs are not required for Roth IRA accounts after "Roth IRA accounts" add "during the lifetime of the Roth IRA owner (but are required after the death of the Roth IRA owner. For more information about RMDs, please visit the RMD Resource Center, which includes FAQs and ideas on how to put an RMD to work or learn more with the Required Minimum Distributions (RMD) Factsheet.
Roth IRA distributions
Unlike distributions from Traditional or Rollover IRAs, withdrawals from a Roth IRA are subject to distribution ordering rules. Any withdrawals are deemed first to come from any previous contributions made, then previous Roth IRA conversions, then earnings.
- Previous contributions: An account holder can withdraw contributions they’ve previously made at anytime and at any age, without income taxes or tax penalties.
- Previous Roth IRA conversions: Withdraw amounts converted from an IRA or qualified plan (not including earnings) income tax free. A 10% penalty tax will only apply if the withdrawal occurs before 5 years have elapsed since the conversion, and the account holder is under age 59 ½ (unless another exception to the 10% penalty tax applies).
- Earnings: Earnings can be withdrawn income tax and penalty tax free after a 5 year holding period and one of the following exceptions exists:
- The IRA account holder has reached age 59½, or
- For a qualified first time home purchase ($10,000 lifetime limit), or
- On account of qualifying disability, or
- Death of the IRA account holder.
DON'T FORGET! Except for 72(t) and RMD withdrawals, the IRS allows a return of distributed amounts back into an IRA within 60 days. Any amounts returned timely are not subject to the income taxes and tax penalties described above.