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If you have multiple options of various different kinds of accounts to choose from, such as an IRA, a Roth IRA, a qualified retirement plan (such as a 401(k) plan) also known as a QRP, and perhaps an inherited IRA; you may be asking yourself: which one should I withdraw from first?
If you’re under age 59½, some of the options include considerable penalties – withdrawals from either the traditional IRA or the QRP will incur a 10% penalty for early withdrawal unless you meet one of the exceptions. So this leaves the Roth IRA or the inherited IRA. Each of these can be taxable to some degree, or partly non-taxable, depending upon the circumstances.
If the inherited IRA was subject to estate tax upon the passing of the original owner, you may be able to take a portion of your withdrawal in credit against the estate tax, due to the IRD tax deduction. In today’s world, this is less and less likely due to the increased estate tax exemption of $12+ million, but it’s still something to consider in your quest.
If you’re age 59½ or older and still working, the 10% penalty will not apply to any of your accounts, but that doesn’t mean that your choice is completely unlimited with no consequences. There are still tax issues to consider, as well as other affects that the law places on you as the owner of these accounts.
At any age, your contributions and conversions more than five years old can be withdrawn from your Roth IRA without tax or penalty. Any growth in the account will be subject to tax and penalty, and any conversions that were completed less than five years ago will also be subject to the 10% penalty.
Since you’re required to take a distribution from the inherited IRA (if you’re not the surviving spouse in some cases), this is where you’ll be taking a withdrawal no matter what other circumstances are occurring. If your need for money is greater than the Required Minimum Distribution (RMD) from the inherited IRA, then the most tax efficient option is to take a withdrawal of your contributions to the Roth IRA.
After those choices, you also could take a loan from your 401(k) plan (as long as this is available). This would be another option that is tax efficient (in general) but you would need to pay back the loan, and in turn this is a good way to derail your retirement savings. This could also result in taxation of your loan amount if you leave employment.
Lastly, you can always take money from your IRA and pay the taxes and penalties. This is probably the least desirable of all the options, as it is the most costly.
Something else to consider, if you have an inherited IRA and you’re not the surviving spouse: you’re required to take the RMD from the account each year, and this can often be a nuisance to keep track of. If you’re in need of money you can take extra from the inherited account and this will reduce future RMDs or perhaps eliminate them if you drain the account. Of course each dollar withdrawn is likely subject to ordinary income tax.
The other thing that makes the inherited IRA the better choice (over your other retirement accounts) is that you can defer use of these accounts until you reach age 73 (for your entire lifetime for the Roth) – and the rate of withdrawal will be less than with the inherited IRA.
In addition, for your owned accounts (non-inherited) your beneficiaries of those accounts can stretch payments over 10 years, or their lifetimes if they are specially eligible designated beneficiaries.
Once you reach age 73 (if born between 1951 and 1959), you must begin taking distributions from your IRAs and QRPs. These are a required minimum amount each year, so you can take the minimum and augment that amount by withdrawing from your Roth IRA options if you have them available.
As in earlier ages, you still need to withdraw the RMDs from your inherited IRAs, this continues throughout your life or as long as there is money in the account.
The goal should be to keep current taxes to a minimum, so using the Roth account may be a good option if you need more money than the RMDs provide for you. However, your Roth IRA is the one account that never requires you to take withdrawals during your lifetime. This can result in a legacy to provide for your heirs – one that will have no tax consequences to your beneficiaries.