You’ve spent decades carefully funneling money into your 401(k), 403(b), IRA, or some combination of retirement accounts. And you’ve likely enjoyed watching your investments grow at an increasingly exponential rate as compound interest works its magic.
Now you’re getting ready to retire, so it’s time to start thinking about how you’ll access the money you’ve been saving so diligently.
But no one has explained how to access that money. Additionally, you need to know the consequences of making withdrawals from your retirement accounts before a certain age if you’re retiring early. And what about the consequences for not making withdrawals after a certain age? Making mistakes regarding retirement withdrawals and distributions could end up costing you a lot of money in penalties to the IRS.
Maybe you assume you should know these things and don’t want to embarrass yourself by asking. Or maybe you simply don’t know who to ask!
But if you have questions about how retirement distributions work or about the consequences that apply when you’re making (or not making!) withdrawals at different ages, you are not alone.
Withdrawing income during retirement is complex. Many people have questions about how to access their retirement income. For that reason, I’ve created a guide to help you learn about the basics of retirement income distributions and withdrawals. I hope that with this guide in hand, you can feel more confident posing your specific questions to a financial advisor.
The Difference Between Withdrawals and Distributions
First, let’s clarify some terminology that is often used interchangeably when discussing retirement income: withdrawals vs. distributions.
Although these two terms can be used to describe the same thing, there are some nuanced differences to be aware of. For the most part, differences between these two terms can be attributed to your age at the time you access money from your retirement accounts.
Retirement Account Withdrawals Before You Turn 59½
When you take money out of a retirement account before you’re 59½, this is considered an early withdrawal. If you withdraw money from a traditional IRA or 401(k) before you’re 59½, you will almost always have to pay a 10% penalty tax on the withdrawal in addition to income tax at your regular tax bracket. If you’re in a high tax bracket, you could end up paying nearly 50% in tax and penalties on the amount you’re withdrawing.
IRS regulations get even more complicated if you’re withdrawing money early from a Roth IRA. True, you won’t have to pay income tax if you withdraw any contributions you’ve made, because you made those contributions with after-tax dollars. However, you may have to pay income tax on earnings for early withdrawals from a Roth IRA.
Early withdrawals from Roth IRAs don’t always come with a penalty. If the account is more than 5 years old and you’re using the money for a qualified expense, you may be able to avoid the early withdrawal penalty. Qualified expenses include situations such as:
- A first-time home purchase (up to $10,000 can be withdrawn penalty-free)
- Qualified education expenses
- Qualified expenses related to the birth or adoption of a child
- Health insurance costs if you’re unemployed
- Unreimbursed medical expenses if you’re unemployed
- You become permanently disabled
- You’ve inherited an IRA
To fully understand the tax implications of an early withdrawal from any retirement account, it’s important to speak to a qualified tax professional about your unique circumstances. With that being said, it’s typically never recommended to take early withdrawals from retirement accounts unless absolutely necessary. Due to the high penalties and loss of potential investment earnings over the long term, early withdrawals usually just aren’t worth it.
Retirement Account Withdrawals Between 59½ and 72
When you’re between the ages of 59½ and 72, you can take withdrawals from retirement accounts penalty-free. For withdrawals made from a traditional IRA or 401(k), you will have to pay income taxes on the amount you withdraw at your current income tax bracket. This does mean that if you’re making large withdrawals over the year, you could bump yourself into a higher tax bracket.
For withdrawals made from your Roth IRA, you won’t have to pay any income tax at all as long as you’ve owned the IRA for 5 years or more. However, if you’ve owned the IRA for less than 5 years, you’ll have to pay income taxes on your withdrawals until you reach that 5-year point. For this reason, it might be better to wait to withdraw from your Roth IRA until you’ve had it for at least 5 years.
Required Minimum Distributions After You Turn 72
If you have a traditional IRA and/or 401(k), you must begin taking required minimum distributions (RMDs) when you turn 72. Before 2020, the age at which retirees had to begin taking RMDs was 70½. However, according to the SECURE Act that was passed by President Trump signed into law in December 2020, 72 is now the age at which RMDs kick in.
At this age, if you don’t take RMDs every year, you could face up to a 50% penalty on the amount of your required distribution, which is a substantial loss. RMDs only apply to traditional IRAs, 401(k)s, and other tax-deferred accounts. Roth IRAs do not require minimum distributions since you’ve already paid taxes on those contributions. Roth IRA investments can continue growing indefinitely.
How Required Minimum Distributions Work
You can calculate your required minimum distribution amount by dividing the balance of your retirement account by a life expectancy factor, which is determined by the IRS. If you have multiple traditional IRAs, you have to calculate the RMD for each account, but you can take the total RMD amount from just one IRA if you wish. RMDs for Qualified Retirement Accounts or Inherited Accounts must be withdrawn from those respective accounts.
To avoid paying hefty penalties, you must take your full distribution amount every year by December 31st after you turn 72. You have the flexibility to decide whether you take the distribution as an annual lump sum withdrawal, through a series of withdrawals, or by scheduling automatic withdrawals through your account administrator.
Many IRA custodians (the financial institution in which your IRA is held) will calculate your RMD for you and remind you about upcoming distribution deadlines. However, we still recommend that you calculate the amounts yourself and verify that you’re taking the correct amounts. The 50% penalty is too high of a price to pay if you do this incorrectly.
Get More of Your Retirement Distribution Questions Answered at Caviness Wealth Management
We hope this guide has helped clarify some of your questions about retirement distributions, but we know that no article could answer every question you have about your own retirement income. Even if you fully understand retirement withdrawal and distribution regulations, it’s still important to develop the right retirement income strategies so you’re not drawing down your income sources too quickly or paying excessive taxes.
At Caviness Wealth Management, we help you create a retirement income strategy that takes into account your most pressing needs and goals. To see how we can answer your more specific retirement income questions and design a strategy that works for you, click here to schedule a conversation.
