Withdrawal Strategies with IRAs

Overcontributing to a Traditional IRA

Traditional IRAs and Roth IRAs differ significantly when it comes to withdrawal strategies, and these differences are reflected from the moment we come up with ideas on contributions onward.

With traditional IRAs, we want to be quite careful not to overcontribute to them, where overcontributing here means any money that we put in being subject to any real risk of early withdrawal. Early withdrawal means at any time prior to when it would be advantageous from a tax perspective to withdraw it.

If we are expecting to enter a lower tax bracket upon retirement, or in any other situation where our marginal tax rate has dropped, or if we are subject to an early withdrawal penalty, we at least need to be aware that this may be a mistake.

It may or may not be a mistake relative to not contributing to an IRA at all, but it may be a relative one given that one of the alternatives would have been to put the money in a Roth IRA.

Withdrawal Strategies with IRAsWhen we contribute to a traditional IRA, the expectation really needs to be to withdraw it at a time where our tax rate has dropped by a lot, in particular, going from 25% to 15%. Whenever we need to withdraw funds from it and this does not happen, or if we are shooting for a lower amount of tax reduction in retirement, a Roth IRA would have been the better choice.

A lot of people mistakenly put money in traditional IRAs with too low of an expectation of tax reduction though, and if we may only expect a reduction of two or three percent, this will not be enough to justify the traditional IRA over the Roth one, as the Roth will then provide not only greater tax benefits but greater flexibility as well.

We do get a benefit out of a traditional IRA even though our marginal tax rate may be the same at withdrawal as it was at the point that we contributed the money, but still can be even better off if we do the same thing with a Roth IRA.

In this case, if we re-invest our tax savings, as we should with traditional IRAs, this borrowed money gets paid back later but it still may have yielded investment profits, if we have enjoyed a positive return in our IRA account while this deferred tax was invested. On the other hand, the entire principal would have grown in a Roth IRA, and would have done so tax free instead of still needing to pay tax on it in a traditional IRA.

Withdrawals and Roth IRAs

Therefore, a significant amount of tax savings, this 10% that we’re speaking of, is needed to make a traditional IRA the better choice of the two, but what we also need to realize is that Roth IRAs also make withdrawals easier to manage.

We can withdrawal amounts we have contributed to a Roth IRA at any time with no implications at all. If we take any money out of a traditional IRA before the age of 59 ½, we are subject to a 10% penalty. While this may still yield a tidy profit net of this penalty from using the government’s money essentially to invest if it has been in there for long enough and we’ve done well enough, this just means that there was a benefit over not putting it in an IRA, which doesn’t mean that this was the best choice of IRA.

There’s also the matter of withdrawing from a traditional IRA without realizing the tax savings. Even though most of our advantage may come not from the reduction in tax but by growing the money we got from the tax deferral, which we have invested for years rather than just handing it over to the IRS, this tax reduction in the end still forms an important component of a traditional IRA strategy and it what makes it preferable in some circumstances over a Roth contribution.

It is never a good idea to withdraw early from any IRA, including a Roth one, and with a Roth we are giving up the ability for the withdrawn money to accrue tax free earnings in the future. Once you take money out of an IRA it is gone forever, with both types.

However, if you do need to make a withdrawal, it is better to do so without any tax consequences or penalties, and a Roth IRA does offer this advantage to a certain point. If you are taking out more than you put in, this additional amount may be subject to the same 10% penalty that a traditional IRA is if you have not reached the age of 59 ½.

While both IRAs do offer some exceptions to this, buying your first home and so on, these generally do not apply to one’s situation. Roth IRAs also allow us to escape the 10% penalty provided that we take out a fixed amount each year up to the age of 59 ½, and this can be advantageous in some circumstances at least.

On the side of the traditional IRA though, should we be out of work for an extended period of time and this leads to our marginal tax rate dropping significantly, we can cash it in and take advantage of this lower rate, like we would do in retirement. If we are old enough to escape the penalty, and our tax rate drops enough, this can make a traditional IRA the better choice in this circumstance.

How Roth IRAs Allow Us to Be More Aggressive in Contributing

Let’s say we have $5000 that we can put away in savings and we’re not sure that we’ll be able to allocate the entire amount to our retirement. We’ll assume that there is a 50% chance that we’ll need $3000 of this before then, and we’re deciding whether we should just put $2000 into an IRA and hold back the other $3000, or put the whole thing in an IRA. Let’s also assume that if we do take it out it will be before age 59 ½.

With the traditional IRA, it may be wiser to hold back this $3000, as we don’t want to pay the penalty and we’re not anticipating that our tax rate will be lower if we need to take it out early, and might even be higher if we get the promotion we’re hoping for in the meantime.

We can be as aggressive as we want to be with a Roth IRA though, because if we don’t put this extra $3000 in, we’ll lose the contribution room for this year, and if we do, we can at least earn money from the extra contribution tax free in the meantime.

If we do need to take it out, we have generated some tax-free earnings over the time it has been in the account, and if we don’t need it, it will generate this income until it is withdrawn later and perhaps much later.

This is why if there is any real uncertainty about needing to withdraw contributions to an IRA, we should be choosing a Roth IRA to contribute these less certain deposits. It may be the case that a traditional IRA is the better choice for the money we know we will not need until retirement, but we still may want to have a Roth IRA account as well to put money in we’re not as sure about, or to cover expenses that may be unexpected.

Even if we are completely sure that we won’t be keeping money in an IRA long term, we can still benefit from putting it in a Roth IRA, because we’re always going to be better off than not contributing it at all, because there will always be some tax benefits as long as the money is in there for at least a full year.

Unwinding IRAs

Once we hit retirement and see the desired tax rate drop manifest, if it does that is, traditional IRAs should be unwound. We may need some of this to manage our expenses, but we do not ever want to take money out of an IRA if we don’t need it, even though the tax rate on it may end up being the same later.

If not for the fact that Roth IRAs exist, the strategy of withdrawing up to the limit of one’s tax rate wouldn’t be a bad idea, but it’s a much better idea to roll over your IRA to a Roth one at this point up to these income limits.

You will have to pay tax on the money anyway, because it is owed, but by paying off this debt now and rolling it over, your money can earn tax free going forward for as long as you don’t need it, even for the rest of your life.

We still need to account for the not continuing to use this tax owed to generate further income, but since we know that a Roth IRA will beat a traditional one if there is no further reduction in tax rate expected, we can comfortably roll over whatever money we can at our current tax rate into an IRA without needing to be concerned that we’re doing the right thing.

At this point in time, the faster we can get our traditional IRA money into a Roth IRA the better, keeping in mind that we do not ever want to exceed the limits of our current tax bracket and end up paying more tax than we would otherwise have to.

We may not be able to further contribute to either type of IRA if our earned income is reduced to zero, but once our money moves in a Roth IRA, there are no further tax consequences ever as long as we are over the age of 59 ½. There is no withdrawal consequence at all other than once we take money out of a Roth IRA and can’t contribute to it further, it is gone from there forever, and we should exhaust all of our non-IRA funds first.

IRAs can be very valuable vehicles to have us ending up with more money in retirement than would otherwise be possible, but we still need to consider all the conditions which we may expect and perhaps not even expect to need this money, and allocate it in a way that minimizes or eliminates any negative effect that these withdrawals may have upon our financial picture.

Robert

Editor, MarketReview.com

Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.

Contact Robert: [email protected]

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