Take Out Your IRA Money? Risks and Effective Solutions

If you’re like me, nearing retirement, or as I prefer to call it, work-optional status, you likely have a good chunk of change in your retirement accounts.

In my case it’s a mix of traditional and Roth Individual Retirement Accounts (IRAs; fun fact: the Internal Revenue Service calls them Individual Retirement Arrangements), traditional 401(k) accounts, and a Health Savings Account (HSA).

Pros and Cons of the Different Account Types

Each of the above types of accounts has advantages.

Traditional IRAs: Subject to income limits, every dollar you contribute to these accounts reduces your taxable income by a dollar, reducing your income taxes for the current tax year.

Roth IRAs: Here, you don’t get a tax deduction when you contribute. Instead, when you withdraw the money (after you’re 59.5 years old) the withdrawals will be tax-free. Once the account has been open for five years, you can (but really shouldn’t) withdraw every dollar you ever put in without owing taxes and with no penalty, no matter your age. There are no Required Minimum Distributions (RMDs; see below) on these accounts for the original owner. In most cases, if the account was open for at least five years, withdrawals made by heirs are tax-free.

Traditional 401(k Accounts): This one is similar to traditional IRAs but is sponsored by your employer. There is no income limit, but there is a contribution limit. Contributions can be deducted from your taxable income in the relevant tax year. In many cases, your employer may contribute a so-called employer match, typically equal to $0.50 to $1 for every dollar you contribute up to a limit, typically between three and six percent of your pay.

Roth 401(k) Accounts: This account is to the traditional 401(k) what the Roth IRA is to the traditional one. Everything is the same as for the traditional 401(k) except the tax advantage which is like that of the Roth IRA. Here too, no RMDs apply to the account.

HSAs: This account type is arguably the best of the lot. There are no income limits (though you have to have an HSA-compliant high-deductible health insurance plan). There is an annual contribution limit. You can deduct your contribution from your taxes. There is no tax on withdrawals made at any time (including immediately) if you use the funds for qualified health expenses. Most people use the money to cover ongoing health-related expenses. I prefer to cover those expenses from other sources and invest the HSA money in growth-oriented mutual funds that offer long-term appreciation that will never be taxed (since I’m sure that, like most people, I’ll have lots of health-related expenses in my old age).

Each account type has drawbacks too.

Traditional IRAs: These have several drawbacks. 

• You have an annual contribution limit. 
• Depending on your income, you may or may not get a tax deduction. 
• You have to withdraw at least your RMD starting the year you reach age 73 (this starting age increases to 75 if you don’t hit 73 before the RMD hits). Failure to make the RMDs leads to a 25 percent penalty.
• Except in limited circumstances, withdrawals made before you’re 59.5 years old have a 10 percent penalty in addition to the tax owed. 
• Any withdrawals (assuming all the contributions were made with pretax dollars) are taxable at your then-current income tax rates. 
• Most non-spousal heirs have until the end of the 10^th year after your death to drain the account, and since there is no step-up in basis, they will generally owe income taxes on those withdrawals at their then-current regular tax rates.

Roth IRAs: These accounts’ drawbacks include the following.

• You have the same annual contribution limit as in the traditional IRA (the limit is shared among all your IRAs, traditional and Roth. Thus, if you’re allowed to contribute to the Roth IRA and contribute half the annual limit there, you may only contribute the other half to your non-Roth IRAs that year.
• There are income limits that reduce or prevent your contributions (you can convert traditional IRAs into Roth IRAs). 
• You don’t get to deduct contributions from current-year taxes.
• Except in limited circumstances, withdrawals before the account is at least five years old are considered by the IRS as non-qualified so you will owe taxes on the earnings portion of the withdrawal. If you are under age 59.5, you will also owe a 10 percent penalty on those earnings.
• Most non-spousal heirs are required to drain the account by the end of the 10^th year after the death of the original owner.

Traditional 401(k): The drawbacks of this account type are as follows.

• You can only contribute if your employer offers such a plan. 
• Some employers don’t offer matching contributions. 
• Fees may be high. 
• Investment options are limited compared to IRAs. 
• There are contribution limits, though they’re far more generous than the IRA contribution limits. 
• RMDs apply to these accounts too.
• Except in limited circumstances, you cannot withdraw money before age 59.5 without paying taxes and a 10 percent penalty.
• Withdrawals are taxed at your then-current regular income rates rather than the lower long-term capital gains (LTCG) tax rates. 
• Most non-spousal heirs have until the end of the 10^th year after your death to drain the account, and since like with inherited IRAs there is no step-up in basis, they will generally owe income taxes on those withdrawals at their then-current regular tax rates.

Roth 401(k): These accounts also have drawbacks.

• Similar to the traditional 401(k), the plan has to be sponsored by your employer.
• Again, your employer may not offer a matching contribution. 
• Here too, fees may be high.
• Just as with the traditional flavor account, investment options are more limited than for IRAs. 
• The same contribution limits apply here as for the traditional plan.
• You don’t get to deduct contributions from current-year taxes.
• The same 10 percent penalty applies to the earnings portion of withdrawals before you reach age 59.5.
• Most non-spousal heirs have until the end of the 10^th year after your death to drain the account, but generally, they will not owe taxes on those withdrawals.

HSA: This account type has few drawbacks.

• The main drawback here is that you cannot contribute more than the IRS-allowed limit. 
• Many HSAs offer only savings accounts that don’t earn much, so you’ll need to find one that offers better options (I use Optum Bank’s plan, but that’s not an endorsement – do your own due diligence). 
• Withdrawals are tax-free only for money used for qualified health-related expenses.

Should You Keep Pouring Money into These Accounts?

Especially as you near retirement, you may not want to keep contributing to traditional plans, since they’re subject to the RMD, and withdrawals are taxed at regular income tax rates, rather than the preferred Long-Term Capital Gains (LTCG) rates that top out at 20 percent (federal).

You may want to consider investing through a taxable account instead, so you have a source of retirement income that enjoys the lower LTCG tax rates.

Chris Chen CFP, Wealth Strategist, Insight Financial Strategists says, “Through financial planning, it can become apparent that the future taxes owed on a contribution will be greater than equal current taxes. At that point, contributing to traditional accounts may not make economic sense. Instead, contributing to a taxable brokerage account would result in less overall taxes, because they would be taxed at the lower capital gains rate instead of the ordinary income rate. In addition, the tax rate in a taxable brokerage account can be further reduced by using tax harvesting.

Chris Boyd-Witherspoon, Defensive Retirement Strategist & Distribution Phase Specialist, American Heritage Financial, agrees, “After you’ve maxed out contributions to your retirement accounts or if you’ll need cash soon, putting money into taxable accounts could be a better option. These accounts are easier to access and may offer tax benefits on profits when you sell investments.”

This does not apply to Roth accounts or HSAs, since withdrawals from those should be tax-free (for HSAs, as mentioned above, the money will need to be used to cover qualified health-related expenses).

When Do People Typically Start Withdrawing IRA Money?

According to the Investment Company Institute (ICI) 2024 factbook, investors in traditional IRAs generally tend to withdraw less frequently early in life. They typically start drawing money out of these accounts later in life, when RMDs hit. 

The ICI data show that in 2019, more than eight in 10 traditional IRA investors in their 70s or older withdrew money from their IRAs. In 2020, the government suspended RMDs due to the pandemic, resulting in a significant reduction in the fraction of investors who made IRA withdrawals – down to six in 10.

For Roth IRAs, where RMDs don’t apply, withdrawals tend to happen even later in life.

In 2020, for investors aged 18 to 59, only three percent of Roth IRA owners and six percent of traditional IRA owners withdrew IRA money. For investors aged 60 to 69, these numbers jumped to six and 19 percent, respectively. For those 70 or older, the Roth fraction stayed at six percent while the traditional IRA withdrawers were up to 60 percent.

What’s the Best Order of Accounts to Draw from in Retirement?

A Charles Schwab study compared three withdrawal strategies.

• One follows the conventional wisdom – tap your taxable accounts first to maximize the tax benefits of your qualified retirement plans. Once you drain your taxable portfolio, tap your tax-deferred accounts – traditional IRA, traditional 401(k), etc. Finally, once those too are tapped out, draw from tax-free accounts such as Roth IRAs, Roth 401(k), HSA, etc.
• The second is a proportional withdrawal strategy – you take proportional amounts from your taxable and tax-deferred accounts until both are drained. Then, you tap your tax-free accounts. This will move withdrawals from tax-deferred accounts earlier than the first strategy.
• Third and last is a personalized strategy – you decide how much to draw from the various account types in a way that manages your tax brackets. You draw from tax-deferred accounts as much as you can without getting pushed into a higher tax bracket. Then, if you need more money, you tap your taxable accounts, which would generally be taxed at the lower LTCG rate. If you need even more money than that, you start tapping your tax-free accounts.

The Schwab study simulated an example scenario and found that after a 30-year retirement:

• The median remaining balance using the proportional withdrawal method was about 11 percent higher than using the conventional method, and the personalized method was about 23 percent higher than the conventional one.
• The estimated median total taxes paid over the 30 years were over 28 percent lower than with the conventional method, and the personalized method was nearly 34 percent lower than the conventional one.
• Allowing the simulations to keep running until the nest egg was depleted, the median possible retirement length was about a year longer for the proportional method (38 vs. 37) and the personalized method was an extra two years longer (40 vs. 37).

Boyd-Witherspoon shares, “We use a mix of account types (taxable, tax-deferred, and tax-free) to give you flexibility and control over your money. We also set up a withdrawal plan to help your money last, considering market ups and downs and inflation.”

What Are Some of the Pitfalls You Could Face If You Don’t Do Things Right?

As mentioned above, withdrawing from your traditional retirement plans before age 59.5 will usually result in penalties and taxes (on contributions and earnings for traditional accounts, on earnings only for Roth accounts). If you need to make early withdrawals, check if any of the exceptions apply to your situation. Even if they don’t, taking “essentially equal” annual distributions may help.

As the Schwab study demonstrated, waiting too long to start withdrawing from your traditional IRA will often lead to higher annual taxes, a lower ending balance, and a shorter period before your nest egg is depleted. To avoid this, figure out how to “fill” your tax bracket with withdrawals from tax-deferred accounts, then use taxable accounts, and only then tax-free accounts. You may need the help of an accountant or financial advisor to personalize your withdrawals each year.

Delaying withdrawals from retirement accounts may push you to claim Social Security Benefits early, which for healthy people who can expect a long retirement would reduce lifetime benefits compared to claiming at age 70 (your retirement benefits grow by about eight percent per year of delay claiming). Try to bring in enough income (side hustle, part-time work, etc.) to cover expenses until you reach age 70 without drawing too much from your retirement accounts.

Converting traditional IRAs to Roth IRAs may be a way to reduce your lifetime taxes, but not always. There are situations where making a Roth conversion will lead to higher lifetime taxes. Consult with a tax planning specialist to figure out if a Roth conversion is a good idea in your personal situation.

Boyd-Witherspoon says, “To reduce taxes when withdrawing money from retirement plans, we suggest taking money from regular savings first, letting your retirement accounts grow longer, or converting some accounts to Roth IRAs during low-tax years to pay less in taxes overall.”

Chen elaborates, “Once a client goes into retirement, or at least reduces their work pace and income, it may make sense to start Roth conversions. With a Roth conversion, a client can take a distribution from a retirement account such as a 401k or an IRA, pay the taxes due, and roll the funds over into a Roth account. After that, the funds in the Roth account can grow tax-free and are distributed tax-free. That is a good way to take a future tax liability, pull it forward, and pay less taxes over a lifetime.”

“Clients instinctively postpone distributions from traditional retirement accounts to avoid paying income taxes on them – who likes to pay taxes? They don’t realize that the longer they postpone a distribution, the higher the overall tax. That is why it often makes sense to plan for Roth conversions or conversions to taxable accounts in low-income years in order to help lower lifetime taxes.”

As mentioned above, if you fail to make your RMDs in full, the IRS will assess a 25 percent penalty on the missing distributions. This is why you need to verify at what age you have to start taking RMDs and take the required amount each year (this will change over time based on your age and the total balances of all your tax-deferred accounts).

Boyd-Witherspoon agrees, “Many people forget about RMDs, leading to big penalties.”

Beyond forcing you to pay taxes, RMDs may push you into a higher tax bracket. Worse yet, they may make your taxable income high enough to dramatically increase your Medicare Part B and prescription plan premiums (up to 3.4 times higher). Managing your withdrawal sources may help you minimize this. Note that a large Roth conversion done after you enroll in Medicare can easily push you into this trap, so make any conversion you may want before age 65.

As Mike Hunsberger, Owner, Next Mission Financial Planning says, “Withdrawals in retirement can be complex. The biggest pitfall I see is trying to minimize taxes this year rather than having the long-term mindset to minimize lifetime taxes for you, your spouse, and even your heirs. Your goal should be to pay less in lifetime taxes including, for those 63 and older, the Income-Related Monthly Adjustment Amount (IRMAA), a surcharge added to Medicare Part B and Part D premiums for higher-income individuals.”

Finally, beyond pushing you into a higher income tax bracket, RMDs and other withdrawals could increase your taxable income to the point that more of your Social Security benefits will be taxable. Note that this happens at relatively low income levels, so most people will already be taxed on the maximum – 85 percent of benefits. Here too, managing how much you draw from each account type may help you avoid or at least minimize this problem.

Chen adds another important matter that very-high-net-worth and ultra-high-net-worth people need to consider, “To optimize a retirement tax strategy, clients should plan earlier rather than later. Many considerations besides taxes go into designing an effective strategy. Clients should also think in terms of minimizing estate tax. The estate tax limit is scheduled to drop by 50 percent in 2026 thanks to the expiration of the TCJA at the end of 2025. At that time, an estate above about $7 million will be subject to the federal estate tax. Many people who are not subject to estate tax now will become subject to it then. Planning for that eventuality should be part of every taxpayer’s retirement tax strategy.”

The Bottom Line

Tax-advantaged plans are crucial for maximizing your retirement nest egg, especially with defined-benefit pensions no longer being available to most people. However, these plans are not all the same. Each has its own set of advantages and disadvantages, as listed above.

The timing of withdrawals has important consequences. You may have to pay penalties and higher taxes if you start withdrawing too early. On the flip side, if you don’t meet your RMDs once they apply, you’ll face even higher penalties. As shown above, there are other potential gotchas you should try to avoid, and how you may be able to do so.

For many of the above issues, a good financial advisor and tax planning specialist can save you a lot more money than the cost of working with them.

Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.