Elective Withdrawals from Traditional IRAs Q&A

Last update on: May 28 2020

By Bruce Miller

After going over the basic points of elective withdrawals from Traditional IRAs (TIRAs) in my previous article, this one will answer a few real-life customer questions to illustrate how the rules governing elective withdrawals apply to actual situations.

My answers are based on my experience and the current guidelines. However, I always recommend that you check for any regulation changes or seek professional advice to make sure that the answer is applicable to your particular situation, especially if the matter is complex.

With that in mind, here are few common situations that IRA owners might encounter when making elective withdrawals from TIRAs.

Q. I have read that if I retire from my employer after age 55 but before attaining age 59.5, that I can make withdrawals from my TIRA and not be subject to the 10% penalty. Is this correct?

A. No, this does not apply to an IRA. This only applies for your employer-sponsored retirement plan, which will avoid the 10% early withdrawal penalty as you’ve pointed out, and it also will avoid the mandatory 20% withholding the IRS requires for elective withdrawals from the retirement plan taken by the employee. But an IRA has no such provision.

Q. If I withdraw from my IRA, is the IRA Custodian required to withhold 20% of my withdrawal and send it to the IRS?

A. No, the custodian is not required to withhold the 20% – unless you specifically ask the custodian to withhold the funds. Most IRA custodians will have fixed rates of withholding you may elect when you take the withdrawal, but a withholding is not required. However, employer retirement plans are required to withhold 20% on an elective withdrawal.

Q. I am 63 years old and this year I took some money out of my TIRA to help pay down part of my granddaughter’s student loans. Can I do this and avoid the 10% penalty on the withdrawal amount.

A. You do not owe a 10% penalty. However, the reason that you are not subject to the 10% penalty is because you are over the age of 59.5, not because of the payment to the student loan. Once you attain the age of 59.5, you are never subject to a 10% penalty on TIRA withdrawals, regardless of how you spend the money. However, if you were under 59.5, you would have incurred a 10% penalty, assuming no other exceptions to it applied. The reason for this is that the withdrawal must be for qualifying educational expenses for you or lineal family members incurred in the year that withdrawal is made – not for previous years.

Q. If I have a financial hardship such as eviction or being unable to pay my utility bills and having my electrical service disconnected, can I be granted an exception to the 10% penalty for a withdrawal from my TIRA. I am 45 years old.

A. No, the exception does not apply to your case. However difficult your life’s situation might be, the only exceptions to the 10% early withdrawal penalty are those approved by Congress. You can find a complete list of the exceptions in the previous article – section 4, points a-h. Occasionally, Congress will grant exceptions for certain hardships caused by natural disasters or economic disasters, but these are sporadic and have termination dates.

Employer-sponsored retirement plans may offer hardship withdrawals while you are working, but they will have their own criteria and eviction is usually one of them. However, such withdrawals are still subject to the 10% early withdrawal penalty. Additionally, the hardship withdrawals must be included as ordinary income that year.

Q. If I take a withdrawal from my TIRA, invest it in a stock, make money and replace the funds back into my TIRA within 60 days, do I have to pay a 10% penalty on the amount of money I made?

A. You do not have to pay the penalty. However, you must declare the amount you made as taxable income. The same would hold for a loss you might have realized from the withdrawn dollars, but a loss does not reduce the amount you must return to the IRA.

Q. I will retire this year from my employer who has offered a generous early retirement option for those of us who have at least 25 years of employment and are at least age 58. I am 58, but I do not wish to begin my pension until age 65 and plan to begin collecting my Social Security at age 62, which is the earliest that I can begin. With my husband’s Profit Sharing plan and my 401(k) plan rollover to our TIRAs, we have about $450,000 that we will need to draw from until I can begin my pension, which along with Social Security will provide sufficient income for my husband and me to cover our expenses and discretionary spending in retirement. What is the best way to draw from our IRAs?

A. Without knowing your exact numbers, it is not possible to speak directly to your question. However, I can offer some general advice.

Any elective withdrawals from your TIRAs before age 59.5 will be includable as ordinary income and will be subject to a 10% early withdrawal penalty. To avoid the 10% penalty and to provide reliable income over the next seven years, you may wish to set up an IRA that will provide Substantially Equal Periodic Payments (SEPP) or sometimes referred to as a “72(t)” relating to the section of the Internal Revenue Code that allows this.

To do this, you will need to calculate the amount you should transfer to the TIRA that you have set up to provide the monthly income you will need. The IRS has approved three methods to calculate the annual – divided by 12 for monthly – withdrawal you will have to make. These three methods are the life expectancy method, the amortization method and the annuitization method.

The latter two methods are fixed and do not change year to year. However, the “life expectancy method” is modeled on an IRA minimum required distribution method and will change each year based on the account value at the end of each year. Your IRA custodian should be able to do these three calculations for you to show you which one will provide the annual amount that you will require. If you continue these annual withdrawals for at least five years or until you reach age 59.5, whichever occurs later, then there is no 10% early withdrawal penalty on the TIRA withdrawals.

Please note that, once you begin, you cannot change until the 72(t) has run its course. There is a one-time only allowance when the IRS will allow a 72(t) owner to change from one of the fixed methods – amortization or annuitization method – to the life expectancy method. This is allowed because if one of the fixed methods looks like it will run out of money before the 72(t) has run its course, switching to the life expectancy method will, by definition, never run out of money. However, the amount paid out can drop considerably. But running out of money in the SEPP IRA would result in all past distributions being subject to the 10% penalty.

The alternative is to use taxable income, such as funds from taxable brokerage or bank accounts. If this is not sufficient to meet income needs, you could take enough from your IRA to provide the bare income you need until the day after you attain age 59.5. These withdrawals will be subject to the 10% early withdrawal penalty, but all withdrawals after that time will not incur the 10% early withdrawal penalty.

Q. At our church, a friend told me that after he retired, he began taking withdrawals from his TIRA each year to make it smaller for the first year he must take distributions at age 70.5. Does this make sense?

A. While this scenario will not be beneficial in most situations, it might make sense in some cases. Those who have rolled over very large amounts from their 401(k), the cash-out value of a pension or other employer retirement plans will have large required distributions when they attain age 70.5. Once individuals retire and lose their employment income, they are usually reliant on Social Security, a pension or both, plus withdrawals from their retirement savings. If there is no pension and they are not yet old enough to begin Social Security, then most or all of their income must come from their savings, which for most people primarily will consist of their IRA.

If a typical new retiree is married filing taxes jointly with his or her spouse and has a household adjusted gross income (AGI) of under $90,000, the odds are that after deductions and personal exemptions, they will be below the $75,900 (2017) threshold for the 15% tax rate. So, if their taxable income (line 43 of form 1040) is, say, $65,000, then they could withdraw from their TIRA or convert to a Roth IRA (for one or both couples) $10,300 and their federal tax rate on the withdrawal would be 15%. By taking advantage of this 15% tax bracket “head room,” they could work to bring down the value of their TIRA in the years leading up to the year they attain age 70.5.

Q. I retired from my employer at age 52 and have left the balance of the cash-out of the pension plan that I elected instead of taking the life pension annuity. I have read that when I turn 55, I can take the lump sum withdrawal and treat it as income without being subject to the 10% penalty. Is this right?

A. I am afraid not. To avoid the 10% penalty for this arrangement, events must occur in the following sequence – turn 55, then retire, then make the withdrawal. For public safety employees, the age requirement is 50. Additionally, please remember that this exception to the 10% early withdrawal penalty only applies to employer-sponsored retirement plans – not IRAs.

Q. I am 61 and this is my first year of retirement. I withdrew $10,000 in February from my TIRA I hold at our credit union and $12,000 in June that is with my brokerage. I made after-tax contributions in past years to my brokerage IRA that total $18,000. How do I figure the pretax and the after tax of my withdrawals this year?

A. On form 8606 that you must file along with your tax return this year, the IRS requires you to total together all TIRAs, SEP IRAs and SIMPLE IRAs you may have and treat this as one TIRA. The value of each will be the total amount as of Dec. 31 of the withdrawal year and must include the total of all withdrawals and any Roth IRA conversions you have made for the year.

Subsequently, you must locate your most recently filed form 8606 that will show the total cumulative basis you have in all TIRAs. Please note that SEP and SIMPLE IRAs may not have any basis. Divide this total basis by the total value of all TIRAs and this will represent the percent of the $30,000 you have withdrawn that will be a withdrawal of basis and not subject to tax. This amount of basis will be subtracted from the most recent form 8606 basis to provide a remaining basis on the form 8606 you’ll file for this year.

I hope that the answers to these few questions have helped you understand some of the real-life implications of the current rules and regulations for elective TIRA withdrawals. Because mandatory TIRA withdrawals are slightly more complex, I will skip those for now and return to that subject at a later point. In the next article, I will go over withdrawals from Roth IRAs.