There are plenty of ways to minimize your tax liability and that’s especially true when you have worked hard to sock away retirement money. Tax advisors are constantly searching for new ways to avoid paying taxes on IRA withdrawals. There are legal strategies you can use to at least minimize the taxes you pay on your individual retirement account (IRA) contributions, but it may be a good idea to speak with a financial advisor before going all in on any one strategy. Try using SmartAsset’s free advisor matching tool to find advisors that serve your area.
Roth IRA and Traditional IRA
If you are planning your retirement and you find yourself asking, “How can I avoid paying taxes on my IRA withdrawal when I retire?” plan ahead and open a Roth IRA instead of a traditional IRA. A traditional IRA is funded with your pre-tax dollars, and you pay taxes when you withdraw the funds. A Roth IRA, however, is funded with after-tax dollars. Since you have already paid taxes on your Roth IRA money, you don’t have any tax liability when you someday withdraw the funds.
What if an emergency happens and you need to make an early withdrawal from your IRA? You still won’t pay any taxes on a Roth IRA if you withdraw only your contributions. If you start withdrawing your earnings from your money then an early withdrawal will trigger taxes. You will have to pay a penalty of 10% on both types of accounts if you withdraw before you are 59 1/2.
There are some hardship exceptions regarding the early withdrawal penalty and taxes. You don’t have to pay a withdrawal penalty in these situations, but you may have to pay taxes, depending on the circumstances:
- Your first home – You can early withdraw up to $10,000 from an IRA without penalties if you put the money toward buying your first home.
- Health insurance – If you become unemployed and you need to purchase health insurance, you can make a penalty-free early withdrawal.
- Military service – If you are called up for military service, or join the military, and serve at least 180 days of active duty, you can make a withdrawal while you are on active duty but not after.
- College expenses – You and members of your family can make an early withdrawal for college expenses like tuition, and room and board and books and supplies.
- Medical bills – If you have medical bills that are over 10% of your adjusted gross income, you can make early withdrawals to pay them.
- Disability – If you become disabled, you are eligible to take early withdrawals.
- Tax lien – If the Internal Revenue Service (IRS) places a tax lien on your property because you owe back taxes, you can withdraw from your IRA to pay your back taxes.
If you take one of these exemptions, be sure and use the money from the IRA for exactly what the exemption provides for, otherwise you may be in trouble with the IRS.
Tax Implications of Having Multiple IRAs
Having multiple IRAs can be justified by several investment strategies. If you have a traditional IRA, funded by pre-tax dollars, and a Roth IRA, funded by after-tax dollars, you may have a winning tax strategy. You can use your yearly contribution to your traditional IRA to reduce your current taxes since it can be directly subtracted from your income. Then, you can use what you deposited into your Roth IRA as access to have tax-free income in retirement.
You can also use multiple IRAs for investment in different asset classes. For example, some investors put their stocks in one IRA, bonds in another and alternative assets like cryptocurrency into a self-directed IRA. This allows the investor to do some analysis concerning the type of asset most beneficial to them.
Instead of having multiple IRAs, you might have a Roth IRA and a brokerage account. If that is your situation, fund your Roth IRA with dividend-paying stocks and bonds that pay interest. Since dividends and interest are taxed at ordinary income rates, you will minimize your tax liability more than if you had those assets in a brokerage account. Put your growth financial assets in the brokerage accounts where you will pay the lower capital gains tax rate when you withdraw them.
Roth IRA Conversion
A Roth IRA conversion is the process of converting your traditional IRA account to a Roth IRA account. The Roth IRA will not require payment of taxes on any distribution after the age of 59 1/2. However, the process of converting the traditional IRA to a Roth IRA creates a taxable event. If you expect your tax bracket to be higher in retirement than it is now, it may make sense to convert your traditional IRA to a Roth IRA. Another strategy is to convert a portion of your traditional IRA to a Roth IRA in years when you expect to be in a lower tax bracket.
There are other strategies that can help you avoid paying taxes on IRA withdrawals, some of which might fly under the radar. For example, you can make donations of securities out of your IRA to a public, approved charity and take up to a 30% tax deduction. If your contribution exceeds the $100,000 per year limit, you can carry it forward for up to five years.
You can also take advantage of the standard deduction. If your taxable income is $0, then you can withdraw the approximate amount of your standard income tax deduction before you are taxed. This amount is around $20,300 if you are married with no dependents.
A qualified longevity annuity contract (QLAC) is another option. A QLAC is essentially an annuity within your IRA that you set up to minimize your tax liability. When you set up a QLAC, you exempt 25% of your required minimum distribution requirements up to a maximum of $130,000. This annuity will last until you are age 85, so it may be worth the premium you have to pay to set it up.
These are some of the strategies you can use to minimize the taxes you will pay when you withdraw money from your IRA. Possibilities involve converting traditional IRAs to Roth IRAs, having multiple IRAs, donating securites from an IRA to a charity or setting up a QLAC. Since many of them involve some complexities, you may want to see a financial advisor so you don’t take the chance of being stuck with a large tax bill at the end of the year.
Tips on Retirement
- A financial advisor can be a huge help when it comes to retirement planning. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Check out SmartAsset’s retirement calculator if you’re looking to plan for retirement on your own. You can use it to determine how much money you may need in retirement.
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