How to Take Money Out of Your IRA

When you turn 70-1/2, you’re no longer allowed to contribute to a traditional IRA. You can contribute to a Roth IRA at any age as long as you have earned income below limits dictated by the IRS. Remember that earned income is money you make from reportable income-producing activities—in other words, a paying job.

Gearing up to take money out of your IRA requires a change in mindset. Fortunately, your IRA provider can be of help here, too.

Getting money out early: 72(t) distributions

Taking money out of a traditional IRA before you turn 59-1/2 is generally a no-no with retirement accounts because it triggers a bad tax day. You owe not only the taxes on the money you took out but also a 10 percent early withdrawal penalty—unless you know the 72(t) trick. This rule is named after an arcane section of the IRS code that says you can take money out without a 10 percent penalty if you do so in “substantially equal periodic payments.”

You must take out the distributions, in equal amounts, for at least five years or until you turn 59-1/2. You can calculate how much money you must take out in three ways: the required minimum distribution method, the fixed amortization method, and the fixed annuitization method. As you can guess from their names, the calculations are complicated. If you’re interested in a 72(t) withdrawal, your IRA provider can help.

You can take money out of an IRA before you turn 59-1/2 without paying the 10 percent penalty in a few other ways, without invoking the 72(t). A big exception for the 10 percent penalty is when you’re permanently or completely disabled. In that case, you can take money out of both a traditional IRA and a Roth IRA. Also, if you die, your beneficiary can take withdrawals.

Taking your required minimum distribution

When you blow out a cake with 70 candles, know that in six months you’ll be in for a big change with your traditional IRA. That’s when Uncle Sam says it’s time for your required minimum distribution (RMD). It must be taken out before April 1 of the year after you turn 70-1/2.

The RMD is calculated using a complicated formula based on your life expectancy. You must take your RMD from all of your traditional IRAs. This requirement is another reason to have your retirement money in one place; you’ll deal with just one annual check.

As part of their service, most IRA providers will calculate your RMD. Vanguard shows the calculation in its RMD calculator, shown in the figure and available.

Don’t ignore the RMD. If you don’t withdraw the RMD and pay the tax, you’ll owe a 50 percent penalty tax on the money you should have withdrawn. Yes, half will be gone in taxes. Most IRA providers calculate your RMD for you and even withhold some of the tax due from what you’re paid. IRA providers will even deposit the money into your account electronically — almost like a paycheck.

Setting up a beneficiary

Your retirement funds are there for you and your spouse, if you have one, or other beneficiary to enjoy later in life. Make sure that your IRA provider knows who to give the money to if you die before your beneficiary. Yes, you could do this in a will, but it’s a better idea to set up a beneficiary. Your beneficiary instructions will take precedence over a will.

When you die, the IRA provider knows to shift the ownership of the IRA to your beneficiary. Listing beneficiaries on IRA accounts is so important that many IRA providers won’t let you fund an account until you choose a beneficiary.

If you have a large or complicated estate or unusual wishes for where your money should go when you die, you might want to create a trust. A trust is a legal entity that can take ownership of assets and follow your instructions in distributing them. Consult with an estate-planning attorney or pick up Estate & Trust Administration For Dummies, 2nd Edition, by Margaret Munro and Kathyrn Murphy (Wiley).

A word about inherited IRAs

Don’t keep your IRA a secret from the beneficiary. After you die and your IRA passes to your beneficiary, new rules kick in. The beneficiary will need to contact the IRA provider and let them know you’re dead. Most IRA providers require a death certificate.

The rules surrounding inherited IRAs vary based on whether or not the IRA is inherited by a spouse. If spouses inherit an IRA, they have a choice on how to take it over:

• Make it their own: Spouses can choose to take over the IRA in their own name. This allows spouses to contribute or take distributions as if it were theirs in the first place.
• Turn it into an inherited IRA: If you go this route, you’ll need to follow rules set out by the IRS, which have many options.

A beneficiary who isn’t a spouse has only one avenue: transferring the IRA into an inherited IRA. Again, your IRA provider will help with the details. If you’d like to read more about how inherited IRAs are handled, check out Vanguard's description. Schwab shows all the inherited IRA rules, too.