Taking Money out of Traditional IRAs and 401(k)s
IRAs and 401(k) plans were designed to be used during retirement for supplemental income. For that reason, there are penalties for taking money out before you reach a certain age. However, the government wants older citizens to take money out of these plans so that the IRS can begin collecting taxes, which have been deferred for many years. These plans therefore require their owners to begin taking distributions once they reach age 70 ½.
As with all government regulations, there are exceptions, but here are the general rules that apply.
Prior to age 59 ½:
Distributions from IRAs and 401(k) plans are subject to tax as ordinary income, plus a 10% penalty unless an exception applies.
Example: You are in the 24% tax bracket and take $100,000 out of your IRA. You will owe $24,000 in federal income tax plus a $10,000 penalty, leaving you with $66,000. You will also owe state income tax on the early distribution of $100,000, and your state may assess an early withdrawal penalty.
There are very limited exceptions to the 10% penalty. These exceptions are for first time home purchasers, some educational expenses, disability or death, certain medical expenses, some health insurance premiums, involuntary distributions from a tax levy, and certain periodic payments. For a more comprehensive list, consult the IRS or a CPA.
After age 59 ½:
Once you reach age 59½, you can withdraw funds from your Traditional IRA or 401(k) plan without restrictions or penalties. Distributions from IRAs and 401(k)s are still subject to tax as ordinary income.
Example: You are in the 24% tax bracket and take $100,000 out of your 401(k). You will owe $24,000 in federal income tax leaving you $76,000. You will also owe state income tax on the $100,000.
Age 70 ½ and over:
Once you reach age 70 ½, withdrawals become mandatory, with limited exceptions for 401(k) plans if you are still working. Beginning the year that you turn 70 ½, you must begin taking an annual Required Minimum Distribution (RMD) from your traditional IRA or 401(k) plan. The amount of your RMD depends on the value of your retirement accounts and your age. RMD amounts start in the 4% range at age 70 ½ and increase with age. The IRS publishes tables with the factor at reach age, but most custodians will perform the calculations for you and tell you the dollar amount you must take.