9 Ways to Avoid Taxes on an IRA Withdrawal

One of the questions financial advisors hear is, “How can I avoid paying taxes on my IRA withdrawal?” While there’s no way to completely avoid paying taxes on your traditional or simple IRA withdrawals, there are a few ways to reduce what you owe on these tax-deferred accounts.

By engaging in active financial planning and learning how to manage your money, you could reduce your tax bill in certain situations. Look at your long-term personal finance needs and where that money will come from. Then, enact the strategies below to optimize your tax return and build your nest egg for the future.

Must-have investing apps for April 2024

Don’t take nonqualified distributions early

Taking withdrawals from an individual retirement account (IRA) before you reach age 59 1/2 is generally considered an early distribution, or withdrawal. You want to avoid early distributions because they trigger an additional 10% tax penalty compared to withdrawing the money after age 59 1/2.

There are exceptions to this withdrawal rule, however. Certain distributions, such as a first-time home purchase allowance, may allow you to withdraw some money from a traditional IRA early without incurring the penalty. IRA funds are generally meant as retirement income, not ordinary income, so it’s best to save it for that purpose.

Use rule 72(t) to avoid withdrawal penalties

If you find yourself facing an early retirement before age 59 1/2, you may need to access your IRA before you planned. But how do you avoid the early withdrawal penalty? Thankfully, the IRS has a special rule called 72(t) that offers you a penalty-free tax break on early withdrawals.

The 72(t) rule exempts you from the 10% early withdrawal requirement as long as you take at least five substantially equal periodic payments (SEPPs) and follow the withdrawal schedule for at least five years or until you reach age 59 1/2, whichever is last.

The amount you need to withdraw depends on your life expectancy as calculated through one of the following IRS-approved methods:

• Amortization method: This withdrawal method creates an annual fixed withdrawal schedule. Payments are calculated by amortizing the balance of your IRA based on your life expectancy calculated by one of the IRS’ life expectancy tables.
• Required minimum distribution (RMD) method: Using the appropriate IRS life expectancy table, dividing your account balance by the number of years the IRS expects you to live to calculate your payments. Payments will need to be calculated every year for the five required years
• Annuitization method: This method sets a fixed withdrawal amount over the five-year period. The calculation factors in your account balance, an annuity factor defined by the IRS, the Federal mid-term interest rate, and your life expectancy.

Don’t miss required minimum distributions

Due to the nature of an IRA, the IRS requires you to take required minimum distributions, or RMDs, each year once you turn age 72 (for those whose 70th birthday is July 1, 2019 or later). If this wasn’t required, people could continue allowing money to grow tax-free while delaying paying regular income tax on the funds in the account.

Once you reach age 72, you must withdraw the calculated required 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, the odds of the tax being more than the 50% excise tax are low.

Time your distributions

Timing your distributions is key when making retirement withdrawals and should be a part of tax planning in general. While withdrawing money when you need it makes for easy budgeting, it may not be the best way to manage your taxes.

Paying off medical expenses or making a home purchase may require a big withdrawal from your IRA. If the timing falls near the end of the year, delaying the purchase to the next year may make sense from a tax perspective. Check your income for the current and next year to see which year would result in a lower amount of taxes you’ll owe.

Be vigilant about where distributions come from

When saving for retirement, you may have used several types of investment or IRA accounts. Traditional IRAs require you to pay taxes when you withdraw funds while Roth IRAs don’t tax withdrawals as long as you follow the rules. What’s more, taxable investment accounts may require you to pay long-term capital gains taxes on withdrawals if you hold on to your investment for over a year.

There’s no problem with mixing and matching withdrawals from several sources throughout the year. Just make sure you still meet the required minimum distributions. Choosing strategically between tax-deductible, tax-deferred, or tax-free retirement accounts can affect what you’ll owe in taxes.

Roll over your IRA properly

Rolling over distributions from a retirement plan to an IRA or an IRA to another custodian is a mostly straightforward process. There are rules in place that must be followed, though.

Not following these rules may subject you to a surprise tax bill. This could happen if part or all of the rollover isn’t completed correctly and treated as a distribution instead. You should always get your new custodian to help you with the transfer to avoid jeopardizing your retirement savings.

Roll funds over 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, you may want to roll over funds from a traditional IRA to a Roth IRA up to that tax bracket’s contribution limit. 

You will still pay taxes on this rollover, but less than you would 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.

Optimize your high-growth investments

Deciding which investments you keep in a Roth or traditional IRA can make a huge difference in the taxes you owe. For many investors, their ideal portfolio contains a combination of investments that reflect different levels of risk and growth.

Since Roth IRAs grow tax-free and give tax-free withdrawals, you never have to pay taxes on the gains. For this reason, some people think they are a smart place to make higher-risk, high-growth investments.

Traditional IRAs, on the other hand, require you to pay income tax on all withdrawals since you deposited pre-tax dollars. For this reason, it could be a smart idea to have these accounts hold your lower-growth assets to help reduce the potential taxable income you’ll owe in the future.

Hire a professional

Taxes are extremely complex and change from year to year. Most people want to optimize their tax situations to minimize their income tax rate for their retirement distributions. To do this consistently and reliably, you’re likely best off hiring a tax professional or financial planner who specializes in retirement planning.

These professionals will charge for their time, but they can think more long-term than even the best tax software. Since they deal with these situations regularly, they may be aware of tax moves you can make that you haven’t thought of. They can also ensure that you’re complying with the tax rules already in place.

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.