Opting into your employers’ 401(k) plan can be a great way to start preparing for retirement. But, if you're looking for 401(k) alternatives, you might consider funding a Roth or traditional individual retirement account (IRA). And to maximize your savings, it’s smart to understand the withdrawal rules when the time comes.
Read more: Learn the differences between a Roth and traditional IRA.
Traditional IRA withdrawal rules
Traditional IRAs allow individuals to contribute earnings into a retirement account toward investments that can grow tax-deferred until they are withdrawn.
Withdrawal age
In the case of both a traditional and Roth IRA, you can start withdrawing funds (or in official terms, "take distributions") after you reach age 59½. At age 73 and over, you must begin taking annual required minimum distributions (RMDs) from your traditional IRA, which must be withdrawn by April 1 of the year after you reach age 73. After that, you must take an RMD by December 31.
The amount of your RMD is calculated by dividing the value of your traditional IRA by a life expectancy factor, as determined by the Internal Revenue Service (IRS). You can always withdraw more than the RMD, but remember that all distributions are taxed as income. If you don’t make withdrawals, you’ll have to pay a 25% excise tax on the amount you should’ve withdrawn. If the error is corrected within two years, the excise tax reduces to 10%.
10% early withdrawal penalty
In general, in addition to being subject to income tax, you'll pay a 10% early withdrawal penalty if money is taken from your IRA prior to age 59½.
When can you withdraw money from a traditional IRA without penalty?
In these cases, you're exempt from having to pay the 10% early withdrawal penalty:
First-time home purchase
In some cases, you can use money from a traditional IRA for a home purchase. If it's your first time purchasing a home, you must use the money within 120 days and you have a pre-tax lifetime limit of $10,000.
Qualified educational expenses
If you or your immediate family members want to pay for qualified educational expenses such as tuition, fees, books, supplies and required equipment without penalty, you can withdraw funds from your traditional IRA.
Disability or death
Suffering from a total and permanent disability allows you to withdraw IRA funds without penalty. Your beneficiaries will not be subject to withdrawal penalties if you pass away.
Medical expenses
If you have medical expenses that amount to more than 7.5% of your adjusted gross income (AGI), you can use IRA funds to pay for it and avoid an early withdrawal penalty.
Birth or adoption expenses
You can withdraw $5,000 to pay for birth or adoption expenses without penalty.
Health insurance
You may be able to withdraw money from your traditional IRA without having to pay a penalty if you are unemployed for at least 12 weeks and if you need money to pay for health insurance for you, your spouse and your dependents.
Involuntary distribution
If you experience a tax levy, you can claim a tax penalty exemption.
Military exceptions
You may be able to take penalty-free distributions if you are a member of the National Guard or a reservist if you are called to active duty for at least 180 days.
Roth IRA withdrawal rules
Roth IRAs are individual retirement accounts that allow you to put after-tax dollars into your account, which means that you do not have to pay taxes upon meeting the withdrawal age.
Withdrawal age
Like a traditional IRA, you must wait until you are 59½ to withdraw your money, but there are exceptions to the early-withdrawal penalty. In addition, IRA withdrawal rules allow you to take out the money you have contributed to a Roth IRA (but not the earnings), even before retirement. That's because you have already paid taxes on those funds.
What is the Roth five-year rule?
Roth IRA withdrawal rules state that in order to avoid paying penalties, you must wait at least five years after your first contribution to make a withdrawal. However, if you take a distribution of Roth IRA earnings before age 59½ the earnings may be subject to taxes and penalties.
Taxes and penalties on Roth IRA withdrawals
If you have money in a Roth IRA for less than five years, your earnings may be subject to taxes but not penalties if you are at least 59½. On the other hand, if you've already met the five-year holding requirement, you can withdraw money from your Roth IRA with no taxes or a 10% penalty at age 59½.
When can you withdraw money from a Roth IRA without penalty?
Taking a distribution of Roth IRA earnings before the account is five years old or before you reach the age of 59½, your earnings may be subject to taxes and penalties. However, you may be able to avoid penalties (but not taxes) in the following situations in some of the same scenarios as the traditional IRA above including:
A first-time home purchase (a lifetime maximum up to $10,000)
A qualified education expense, such as tuition, fees, books and supplies
Birth or adoption expenses up to $5,000
Death or a total and permanent disability: Either you or your surviving beneficiaries can access the money in those scenarios
Involuntary distribution: If you experience a tax levy, you can claim a tax penalty exemption
Military exceptions: if you are a member of the National Guard, a reservist or are called active duty for at least 180 days
Unreimbursed medical expenses greater than 7.5% of AGI or health insurance (if you’re unemployed)
It's worth mentioning that in the case of substantially equal periodic payments (SoSEPP), you can receive a distribution of funds from a traditional or Roth IRA or other qualified retirement plans prior to the age of 59½ and you won't incur IRS penalties in the case of withdrawals.
Pros and cons of IRA withdrawals
Pros of early withdrawals:
You can avoid penalties: These funds can act as an alternative to your emergency fund if you meet the requirements for an exception.
You may avoid debt: If you use money to help you pay for medical expenses, withdrawing early can keep you from incurring debt.
Cons of early withdrawals:
You may face a 10% penalty. Even with exceptions, you may still have to pay tax on your withdrawals.
Limited time to repay: If you plan to repay your withdrawal, you’ll have a 60-day period in which you must deposit funds back into your account.
May never “catch back up”: The maximum total annual contribution limit for all your IRAs combined is $7,000 if you’re under age 50 and $8,000 if you’re 50 or older. You’ll miss out on compounding interest if you withdraw your money.
Check with a financial advisor or accountant to see how IRA withdrawal rules would affect you in the event of such withdrawals.
Saving your savings
Preparing for retirement can involve a lot of details. By understanding when you can withdraw from your IRA, you can avoid penalties and fees while preparing for the future.
