Since its inception in the 1970s, the IRA has become one of the most popular available retirement savings vehicles. Americans hold nearly $2.5 trillion in individual retirement accounts (IRAs). Those nearing retirement, between the ages of 60 and 64, have an average of $165,139 in their IRA.1 If you’re like many Americans, you’ll rely on your IRA for a significant portion of your retirement income.

One of the biggest reasons traditional IRAs are popular is their favorable tax treatment. You can take a tax deduction for your contributions to a traditional IRA. All IRAs also offer tax-deferred growth. That means you don’t pay taxes on your gains as long as the funds stay inside the account.

While IRAs may offer a tax-favored method for accumulating retirement assets, they can also generate tax exposure in retirement. It’s important to understand how your IRA distributions could be taxed so you can plan accordingly. Below are a few important guidelines to keep in mind:

Traditional IRA
The traditional IRA was the first type of IRA introduced. Assuming you meet income guidelines, you can make tax-deductible contributions to your traditional IRA. You can allocate your contributions to a wide range of investment options based on your specific goals and needs. The funds then grow on a tax-deferred basis inside the account.

Traditional IRAs provide an upfront tax benefit, but they also create tax exposure in retirement. Distributions from traditional IRAs are taxed as income. If your traditional IRA will provide a significant portion of your income in retirement, you could have a sizable tax liability.

Remember, you don’t face any taxes until you take a distribution. However, you can’t delay your distributions forever. Traditional IRAs have something called required minimum distributions (RMDs), which start at age 70½. At that time, you’re required to withdraw a minimum amount. Those withdrawals continue for the rest of your life, and the amount could increase as you get older.

Roth IRA
The Roth IRA has gained popularity in recent years because it can be used to create tax-free retirement income. It shares similarities with the traditional IRA but also important differences. Like a traditional IRA, the Roth offers tax-deferred growth as long as your funds are inside the account.

Unlike a traditional IRA, however, your Roth IRA contributions are not tax-deductible. Also, all your Roth withdrawals are tax-free, assuming you are over age 59½ and the account has been open at least five years.

Roth IRAs also don’t have RMDs. That means you can keep your funds in the account as long as you want. In fact, you never have to take a distribution if you don’t want to, and the balance is passed tax-free to your beneficiaries.

Early Distribution Penalty
All IRAs have what’s called an early distribution penalty. Remember, IRAs are meant to be retirement savings vehicles. That means you’re not supposed to take money out of the accounts unless you are retired.

For penalty purposes, the IRS considers 59½ to be retirement age. If you are 59½ or older, you can take IRA distributions without facing a penalty. If you are younger than that age, however, you could face a 10 percent penalty on your distribution. There are some exceptions for things like medical issues and disability. However, you should expect to pay a penalty if you want to take an early withdrawal.

Ready to plan your IRA distribution strategy? Let’s talk about it. Contact us today at MasterPlan Retirement Consultants. We can help you analyze your needs and develop a strategy. Let’s connect soon and start the conversation.

1https://www.fool.com/retirement/2016/06/27/heres-how-much-the-average-american-has-in-an-ira.aspx

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