IRAs are a great way for anyone to save money for retirement. With the current state of the economy, many people may be tempted to withdraw early from their retirement accounts. What they may not know is that doing so could cost them a lot of money, leaving them in a worse spot than they were previously. This and other mistakes cost retirees millions every year, but they can be avoided, if you know your IRA laws, and if you have a strategy that will allow you to get the most out of those laws.
This affects those people who want to withdraw early from their retirement accounts. Know that withdrawing early is a bad idea, unless you need the funds to deal with some kind of emergency (some exceptions are available, including hardship withdrawals and an exception to withdraw up to $10,000 if you are a first-time homebuyer). Most people approaching retirement age know that they will be hit with a 10% penalty if they withdraw funds from their IRA before reaching age 59½. Although it is possible to avoid this penalty using the exceptions mentioned above, but it’s better to just wait a bit longer. You should also know that the IRS is very specific about the 59½ year cutoff, up to the day. So if you try to withdraw 181 days after your birthday, you will be in for a big surprise around tax time (in the form of that 10% penalty).
If you do a little rearranging of your accounts, make sure you are smart about it, otherwise you might have to pay tax on that money at the current income tax rates. Rather than withdraw your money and deposit it somewhere else, do a custodian to custodian transfer. This means the banks will transfer the money amongst themselves and you won’t have to touch the money. If you withdraw your money, you have 60 days to deposit it somewhere else, or it will be figured in with your income for the year (and you’ll be hit with the 10% penalty if you’re under 59½). This could expose you to a huge tax bill. The best solution is to avoid the problem entirely, and let the banks do all the dirty work.
A Roth conversion shifts money from a traditional IRA into a Roth IRA. The benefit of making this change is that you will change the status of your IRA from tax-deferred to tax exempt. With a traditional IRA, you pay no taxes on your contributions, only on withdrawals. A Roth works the opposite way; you pay taxes up front so you don’t have to pay them when you make withdrawals. A Roth conversion works like a vaccine shot against future tax increases, and now is a good time to make the conversion, when taxes are at historic lows. The problem is that you will need to pay taxes on the full balance of your conversion in the year you make it. So if you’re thinking of performing a Roth conversion, it’s a good idea to set aside some money in advance to pay the taxes on the money you will convert.
Many people use the money in their accounts to pay the tax bill, but this can take a sizeable chunk out of their savings. Since any money converted to a Roth IRA will be counted as income for that year, you will actually end up paying tax on the money you used to pay the taxes on your Roth conversion. You will also most likely be bumping yourself into a higher tax bracket, meaning you will pay a higher rate on the rest of your (non-IRA) income for the year. One more thing to consider: The more money you have in your new Roth IRA, the faster it will grow. So why would you want to take money out of your account to pay your tax bill? If you pay the tax bill with money from your IRA, it could take years to recoup those losses and get back to your original sum.
Another benefit of a Roth IRA is that you won’t have to take Required Minimum Distributions (RMDs) like you would with a traditional IRA. With a traditional IRA, when you reach age 70½, you are required to withdraw a certain percentage of your IRA each year (based on your life expectancy). This happens whether or not you are still working, and whether or not you actually need the money. This will also increase your tax liability, as the traditional IRA will require you to pay taxes on your RMD when making a withdrawal. With a Roth, you can keep the money in your account as long as you want without having to take an RMD. And if you never end up using the money in your Roth IRA, you can pass it on to the next generation, something that is simply not possible with a traditional IRA. Employing these strategies can save you a great deal of money as you make the transition from your accumulation phase to your retirement phase.