Your retirement accounts may fund a substantial portion of your post-retirement income. If retirement is getting closer (or even if it’s still years away), it’s essential to know the rules for withdrawals so that you understand your options. Equally crucial, knowing how your plans work will help you avoid making mistakes that can result in unnecessary penalties. There are successful retirement strategies, and there are not-so-successful strategies, and at Global View, we’ve seen them both!
As financial advisors in Greenville, SC, we get a lot of questions about how retirement plan withdrawals work. Why is there so much confusion?
For one, withdrawal regulations differ between IRAs and 401(k) accounts. Moreover, Traditional and Roth accounts observe different withdrawal rules. You must include withdrawals from Traditional accounts in your gross income for the year, while Roth withdrawals are tax-free, but only if you follow the rules.
With a new year quickly approaching, the team at Global View has compiled some of the most critical facts about retirement account withdrawals. Keep in mind, retirement planning is different for everyone. If you have a question that is not addressed here or are wondering how to make up for a late start to retirement planning, talk with a financial advisor. Financial advisors for retirees can be the difference between successful retirement strategies and outliving your money.
To get started, here are some helpful definitions from the IRS:
- Adjusted Gross Income (AGI): Gross income minus adjustments to income.
- Adjustments to Income: Educator expenses, student loan interest, alimony payments and contributions to a retirement account are all income adjustments.
- Gross Income: This is income that includes your wages, dividends, capital gains, business income, retirement distributions as well as other income.
These terms are important to keep in mind when considering your retirement withdrawal options.
Penalties for Early Withdrawals
The most significant commonality regarding qualified retirement accounts is the definition of an early withdrawal – it’s when you withdraw money before age 59-½. If you take an early withdrawal, you’ll face a 10 percent penalty tax, unless you qualify for an exception (described in more detail below).
The second early withdrawal rule applies to Roth accounts. You’ll face a 10 percent penalty when you withdraw income (not contributions) from a Roth account within five years of opening the account. There are no exceptions to this rule. Withdrawals of Roth contributions are never taxed or penalized since you already paid the taxes on those funds at the time of contribution.
Exceptions to the Above Penalties
How to avoid the 10 percent penalty for withdrawals before age 59-½ differs between IRAs and 401(k)s.
IRA Penalty-Free Withdrawals:
Substantially Equal Periodic Payments (SEPPs)
You don’t have to wait until age 59-½ to begin taking penalty-free withdrawals if you observe two rules:
- You must withdraw the same amount each year.
- You must make withdrawals for five years or until your turn 59-½, whichever occurs later.
There is no withdrawal penalty if you can’t work due to a permanent disability. You may have to provide proof to the IRS.
Unreimbursed Medical Expenses
You can withdraw funds from your IRA penalty-free to cover medical expenses that occurred in the same calendar year you withdraw the funds, but two rules must apply:
- You paid the expenses out of pocket because you lack health insurance, or your policy didn’t cover all medical costs.
- Your unreimbursed medical expenses must be greater than 10 percent of your adjusted gross income.
Health Insurance Premiums
Under certain conditions, you may withdraw money from your IRA penalty-free to pay for health insurance premiums. Those conditions are:
- You are unemployed.
- You collected unemployment compensation for 12 weeks in a row.
- You made the IRA withdrawals during the current or following year you collected the unemployment compensation.
- You withdrew the money no later than 60 days following the resumption of work.
Expenses for Higher Education
You can escape the 10 percent penalty to cover qualified education expenses (tuition, fees, books, supplies and required equipment) for you, your spouse and your children. For students attending school at least half-time, room and board also qualify. The IRS rules governing this exception are very detailed, and you will want to work with your financial advisor to get it right.
For other ways to help with paying your children’s college education, check out our recent blog posts:
You can withdraw funds to pay for buying, building or rebuilding your home, but the following rules apply:
- You cannot have owned a home in the previous two years.
- The maximum lifetime exception is $10,000.
- A spouse can also withdraw up to $10,000 for the same house.
- The home must belong to you or a family member who satisfies the two-year rule.
Called to Active Military Duty
Penalty-free withdrawals are available for qualified reservists or National Guard members who were called for at least 180 days of active duty. You may be able to repay the distributions within two years following the end of your active duty.
IRS Tax Levy
The IRS can levy your IRA for unpaid taxes without triggering the 10 percent penalty. The exception doesn’t apply to withdrawals you make to avoid the levy.
Inheriting an IRA
Generally, IRA beneficiaries don’t pay the 10 percent penalty on early withdrawals from an inherited account, although there are some exceptions to the exception. Talk with a financial advisor for specific details and how they pertain your situation.
401(k) Penalty-Free Withdrawals:
The following IRA exceptions apply to 401(k)s too, as well as to 403(b) and 457 plans, in most cases.
- IRS tax levy
- Unreimbursed medical expenses
- Call to active military duty
In addition, 401(k)s provide these exceptions:
Separation from Service
The early-withdrawal penalty doesn’t apply if you separate from your job during or after the year you reach age 55. Age 50 applies to certain governmental and safety employees who belong to a defined benefit plan.
Dividends from an Employee Stock Ownership Plan (ESOP)
You won’t pay an early withdrawal penalty by withdrawing ESOP dividends from your 401(k). (For more on your company stock options, read our recent blog post: Financial Advisor in Greenville SC: What to Do With Concentrated Stock Options.)
The 10 percent penalty also doesn’t apply to withdrawals under a court-ordered qualified domestic relations order (typically a divorce agreement).
For more on how a divorce can impact your retirement, read our recent blog posts:
Required Minimum Distributions (RMDs)
You must begin taking Required Minimum Distributions from your Traditional IRA or 401(k) once you reach age 72. However, if you are still working at that age, you can postpone your 401(k) RMDs. Failure to take your RMD results in a 50 percent penalty.
Lump Sum Vs. Lifetime Payments with Your Pension
According to the IRS: “Most distributions (both periodic and nonperiodic) from qualified retirement plans and nonqualified annuity contracts made to you before you reach age 59-½ are subject to an additional tax of 10 percent.” This penalty applies only to the taxable portion of the withdrawals, and various exceptions exist.
Again, this is a complex topic that you should discuss with a financial advisor.
When in Doubt, Ask!
Withdrawals are but one aspect of your retirement planning. At Global View, we help professionals retiring in Greenville, SC and nationwide plan for retirement, and then navigate the transition when the time comes. In our experience, it’s never too soon to start planning for the future.
If you have any questions about your retirement plans, let’s talk! We can schedule a no-obligation conversation to discuss your retirement plans, your goals and your concerns. Together, we can work out the best solutions to fit your unique circumstances.