The tax advantages of traditional IRAs are counterbalanced by strict rules about when and how distributions can be taken. Early withdrawal penalties evaporate before you reach age 60, and mandatory withdrawals do not start until after age 70. However, missing or miscalculating your mandatory distributions can result in a sizable penalty.
Age 70 1/2 Rule
The IRS requires that traditional IRA owners begin taking distributions from their accounts at age 70 1/2. You are free to withdraw all the money in one lump sum or take out what are termed required minimum distributions each year. You have to take your first RMD by April 1 of the year after you reach 70 1/2. For example, if you saved $100,000 in your IRA, you could withdraw the entire $100,000 or withdraw $10,000 a year, so long as $10,000 meets the required minimum distribution.
Lump Sum Withdrawal
You are free to withdraw as much money as you like from a traditional IRA without penalty after age 59 1/2. Though it might sound tempting to reap the benefits of your disciplined savings habits all at once, there is a downside to the lump-sum option. Traditional IRA withdrawals must be reported as income when you file your return. A lump-sum could push you into a higher bracket and eat up a sizable chunk of your IRA money.
Required Minimum Distribution
The RMD is calculated by dividing the IRA balance as of December 31 of the current year by an age-related figure on an IRS life expectancy table. Most taxpayers use the Uniform Lifetime Table. On the table, a distribution period figure corresponds to each given age. The distribution period figure represents the joint life expectancy of the IRA owner and a beneficiary who is 10 years younger.
The distribution period figure decreases as the age numbers go up. For example, the IRS distribution period figure for IRA owners who are 75 years old is 22.9; for those who are 76 years old, it is 22.0. In addition, your account balance can be expected to be different at the end of every year. Consequently, you must figure the RMD each year. For example, say you have $500,000 in your traditional IRA December 31 of the year you turn 75. Calculate the RMD by dividing $500,000 by 22.9. to arrive at $21,834.
If your spouse is more than 10 years your junior and is the sole IRA beneficiary, use the Joint Life and Last Survivor Expectancy Table to calculate the RMD. Beneficiaries use the Single Life Expectancy Table.
RMD Penalty Tax
The RMD must be withdrawn by December 31 of each year after age 70 1/2. If you turn 70 1/2 in 2018 and take your first RMD April 1, 2019, you must withdraw your second RMD by December 31, 2019. Often, the IRA trustee figures the RMD amount and distributes the money.
However, if you fail to take out the RMD each year, the IRS penalty falls on you and is quite severe. You will have to pay 50 percent of the amount you should have withdrawn but did not. For example, if your RMD is $4,500 and you withdraw only $3,500, you have to pay the IRS $500 as a penalty. Penalties can take a big bite out of your IRA balance, so timely RMD withdrawals are a must.