7 Ways To Avoid Taxes on an IRA Withdrawal

If you have an individual retirement account (IRA), you probably already know that there are rules about how and when you can pull out funds or take distributions. And along with these rules, there are more than a few tax considerations.

While there’s no way to avoid paying taxes on an IRA completely, you may be able to save on taxes for withdrawals. By actively planning for these, you can reduce your income tax bill now (or in the future) and avoid penalty fees. Look at your long-term personal finance needs and where that money will come from. Then, try these strategies to optimize your tax return and keep your nest egg padded.

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When do you pay taxes on IRA withdrawals?

When do you pay taxes on IRA withdrawals?

One of the key benefits of an IRA is that it’s tax-advantaged. Depending on the type of IRA you have, you’ll either pay income taxes on contributions or withdrawals, but not both. Simply put, you’ll either get tax benefits when adding money or taking it out.

• Roth IRA: You contribute money after you’ve already paid taxes on it, so you don’t have to pay taxes when you make withdrawals.
• Traditional, SIMPLE, or SEP IRA: You contribute money before you’ve paid taxes on it, so you generally have to pay taxes when you make withdrawals.

Another important difference between Roth and traditional IRAs is that you can withdraw contributions to a Roth IRA without paying income taxes or penalty fees at any time (but you’ll owe taxes on earnings you take out unless your Roth IRA is at least five years old). On the flip side, you’ll pay taxes on any withdrawals from a traditional IRA and penalty taxes on top of that if you’re younger than 59 1/2. Some people choose one or the other, but some people have both.

Tips to withdraw from an IRA without paying taxes

1. Make sure early distributions are qualified

Taking withdrawals from a traditional IRA before age 59 1/2 (or a Roth IRA you started less than five years ago) is generally considered an early distribution or withdrawal. You want to avoid early distributions because they trigger an additional 10% tax penalty that wouldn’t apply if you waited, and this is on top of normal income taxes that will apply.

There are exceptions to this withdrawal rule, however. Distributions that wouldn’t be taxed include those for:

• First-time home purchases (or builds/rebuilds)
• Births or adoptions
• Disability (requires confirmation from a physician)
• Medical insurance expenses during unemployment
• Unreimbursed medical expenses
• Terminal illness (requires certification statement)
• Higher education from an eligible institution
• Disaster or disaster recovery
• Select corrective distributions
• Qualified reservist distributions

For the full list of exceptions and detailed requirements for each, visit this IRS page about IRA distributions.

2. Time your distributions

Timing your distributions is key when making retirement withdrawals and should be a part of your regular tax planning. While withdrawing money whenever you need it can be tempting when you’re short on funds, it isn’t the best way to save on your taxes.

Making a large withdrawal from your IRA may make sense in some cases, but you should be strategic about when you do it. If the timing of an expense falls near the end of the year, try delaying the purchase to next year if you need to avoid hiking your income taxes up this year — especially if doing so would put you in a higher tax bracket. Your tax bill will go up if you have to report distributions as income, so you’ll need to make sure to set aside enough funds to cover the difference.

3. Spread your withdrawals across different accounts

When saving for retirement, using several types of investment or IRA accounts is common. For example, I’ve held traditional IRAs, Roth IRAs, traditional 401(k)s, and HSAs all at the same time.

If you have a combination of tax-advantaged and taxable retirement accounts, I recommend mixing and matching withdrawals from several sources throughout the year, making sure you still meet the required minimum distributions. Choosing strategically between tax-deductible, tax-deferred, and tax-free retirement accounts can help you save on taxes now and set yourself up for healthy savings in the future, too.

4. Understand IRA rollover and transfer tax rules

Rolling over funds from one IRA to another can make your life easier if you have a lot of accounts to manage. This is called an IRA-to-IRA transfer. You can also roll IRAs into other types of retirement accounts, such as 401(k)s, and vice versa. These are referred to as rollovers.

With both of these, there are rules you need to follow to avoid a surprise tax bill. These include rules about how the money is moved. You won’t pay taxes on transfers between IRAs or rollovers where funds are moved directly from one account to another (a direct rollover), but you may pay taxes if a distribution lands in your bank account before going to your new account.

If you’re opening an IRA for a transfer or rollover, ask your new custodian for help initiating it. Dedicated specialists are often available to walk you through the process.

5. Roll over traditional IRA to a Roth IRA in low-tax years

You can help lower your future tax bills if you do a rollover to a Roth IRA during a low-tax year. If you fall in a lower income tax bracket than usual in one year, or your income decreases indefinitely, you may want to roll over funds from a traditional IRA to a Roth IRA, up to your current tax bracket’s contribution limit.

You’ll still pay taxes on this rollover, but less than during a higher-income year. This will lower the taxes you pay now and let you withdraw money tax-free from the Roth IRA in the future.

I think of it this way: Traditional IRAs are best when you think you’ll be making less money than you will in the future/retirement, and Roth IRAs are best when you think you’ll be making more. When you’re making less money, you can do yourself a favor now by reducing your taxable income. When you’re making more, you can help your future self out by getting the taxes out of the way and setting yourself up for tax-free withdrawals.

How to avoid extra taxes and penalties

1. Take advantage of rule 72(t) to avoid withdrawal penalty taxes

If you find yourself looking to retire before you’re 59 1/2, you may be able to avoid at least the early withdrawal penalty taxes under a special rule in Section 72(t)(2) of the tax code. This rule, affectionately called rule 72(t), offers a penalty-free tax break on a series of withdrawals scheduled and calculated according to your life expectancy.

It exempts you from a 10% penalty when you take at least five substantially equal periodic payments (SEPPs) and follow the withdrawal schedule for five years or until you reach age 59 1/2, whichever is later.

The IRS has approved three methods for calculating SEPPs:

• Amortization method: Creates an annual fixed withdrawal schedule. Payments are calculated by amortizing the balance of your IRA based on your life expectancy and approved interest rate, as determined by IRS guidelines.
• Required minimum distribution (RMD) method: Using the appropriate IRS life expectancy table, divide your account balance by the number of years the IRS expects you to live to calculate your payments. You’ll need to recalculate every year for the five required years
• Annuitization method: Sets a fixed withdrawal amount over five years. The calculation factors in your account balance, an annuity factor defined by the IRS, the Federal mid-term interest rate, and your life expectancy.

You’ll still pay income taxes on withdrawals, but you can at least avoid penalties on top of this. This rule also applies to other types of retirement accounts, including 401(k)s and 403(b)s.

2. Take your required minimum distributions

To limit how long people can dodge taxes on traditional IRAs, the IRS requires you to take required minimum distributions or RMDs each year when you turn 72 (for those whose 70th birthday is July 1, 2019, or later).

Once you reach age 72, you must withdraw the calculated minimum distribution each year. If you don’t, you’ll have to pay a 50% excise tax on the amount you were supposed to withdraw. While you’ll have to pay tax on your IRA distributions, you won’t pay more than 50% in taxes because income tax rates don’t go that high (they cap out at 37%).

Bottom line

Depending on your situation, you could have several options available to you to help avoid taxes on an IRA withdrawal. If you feel like you’re in over your head, you may want to consider consulting a financial advisor or Certified Public Accountant (CPA). They can help you figure out the most tax-efficient ways to manage your IRAs and other investments.

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Get a 3% match on your eligible retirement contributions¹

No traditional employer needed to get the match

Open a Roth IRA or a traditional IRA

Receive a one-time custom-recommended portfolio²

Build your own investment plan

No commission-fees (other fees may apply)