While sitting in the stands at Phoebe’s softball game last weekend I got to speaking to the parents of one of her teammates—let’s call them June and David. June and David, Cutter Family Finance “faithful,” had a few questions about finance.

Hmmm...right up my alley. Even Phoebe’s pitching takes a back seat to the faithful!

June and David are from Duxbury, about my age, in their early 50s, with three kids of their own. He is an electrician and she is a teacher’s aide in the schools. They are interested in installing a new pool in their yard over the summer. In particular, they wanted to learn about strategies that could be used to pay for it, with the least financial impact.

Naturally, that meant considering their available financial resources.

I was somewhat disappointed when the discussion turned to taking the money out of their Individual Retirement Account (IRA) for this project. You see, while the IRA is a retirement savings cornerstone for many Americans—with about 42.6 million American households owning IRAs in 2018—it seems that not everyone fully appreciates their purpose and how they work. The good news for June and David is that they decided to talk to me before they act, which gave me the opportunity to explain the consequences of taking money from their IRAs too early, and also gave them some insights into how IRA distributions work in general.

I suspect that you, too, would appreciate this information. So this week I decided to share with you my chat with June and David.

The most important rule to bear in mind is that the money you take from your IRA might be taxable. And, there are different tax consequences for traditional IRAs and Roth IRAs.

First, traditional IRAs. Earnings accrue on a tax-deferred basis in traditional IRAs, and distributions are treated as ordinary income, with any pre-tax amount that is included in the distribution being taxable. Taxable amounts are subject to a 10 percent additional tax, if the distribution is taken before the owner reaches age 59½ (early distribution), unless an exception applies. Imagine taking a distribution of $50,000, and come tax time finding out that you not only owe income tax on it, but you also owe the IRS an additional $5,000 in penalties because you took the money “early.”

I find that it is rarely advisable to use your retirement savings to pay other expenses—because you may lose the benefit of tax deferral and its compound interest—which can hamper your retirement savings strategy. But life happens, and in some cases you may have no reasonable alternative. The good news is that in certain instances, you may avoid the 10 percent additional tax. The bad news for June and David? A pool is not one of those instances.

You can continue to leave the money in your traditional IRA to grow tax-deferred until you reach age 70½, at which time the IRS requires you to begin taking distributions, known as Required Minimum Distributions (RMD). Your RMD at 70½ can be delayed until April 1 of the following year. For every other year, you must take your RMDs by December 31. And if you do not take your RMD on time, you’ll owe the IRS a 50 percent penalty on the shortage—that’s right, 50 percent penalty on the amount not withdrawn.

Your RMD is calculated by dividing your retirement account balance at the end of the previous year by a factor provided by the IRS, based on your age. As a result, this number will change from year to year. Investors who are unprepared for RMDs find themselves getting pushed into higher tax brackets—and worse. That’s because, for income calculation purposes, RMDs are added together with other sources of income, including half your annual Social Security benefits; and if the total exceeds certain thresholds, the tax consequences can be harsh.

Accordingly, it is absolutely crucial for you to understand the impact that RMDs will have on your retirement income stream. You should have a strategy in place to help manage your investments, income, and taxes as effectively as possible so when the time comes, you are prepared.

I went on to discuss the Roth IRA, since a total of 22.5 million households owned Roth IRAs in 2018. With a Roth IRA, contributions are made with after-tax dollars, so there is no tax deduction. However, you can take withdrawals at age 59½ or later with no taxes or penalties, as long as you have had a Roth IRA for at least five years, starting January 1 of the first year you fund a Roth IRA. There is a crucial qualifier: If you do not meet these two requirements, you will pay income tax on any earnings included in your distribution. And, except for distributions of your regular Roth IRA contributions, you might owe the 10 percent additional tax if you are under age 59½ when you take the distribution.

One significant advantage of Roth IRAs: They have no RMD requirement for owners, which means the money in that Roth account can continue to grow tax-deferred (with earnings eventually becoming tax-free) until you’re ready to use it. What’s more, because your regular contributions are made after tax dollars, you can withdraw those amounts at any time, for any reason, with no taxes or penalties. Tip: Just don’t touch your Roth earnings, until you meet the two requirements explained above.

We also talked about moving 401(k) money to IRAs. Investors often want to roll over their 401(k) accounts to traditional IRAs, and for good reason. Very often, they gain more control over their investment choices, which is especially beneficial if the 401(k) plan offers limited investment options. But I warned them to be careful here, because the IRS does impose a 60-day limit on rollovers of distributions that are paid to the investors. Generally speaking, if you go longer than the 60 days, you can no longer do the rollover and the IRS treats it as a withdrawal and imposes applicable penalties and taxes. I explained that the preferred option would be to do a direct rollover that is facilitated directly between the plan provider and new IRA custodian, as there would be no risk of the amount being taxable because of missing the 60-day deadline.

The IRS allows you to roll over traditional IRAs, 401(k) plans, Roth 401(k) plans, 457(b)s and others into Roth IRAs; some investors find the tax benefits of Roth IRAs appealing enough to do these rollovers. Bear in mind, though, that when you roll over one of these pre-tax accounts to a Roth IRA, you will owe income tax on pre-tax balance in the year of the rollover. Please make sure you reach out to a qualified retirement specialist before doing this.

I wrapped up the conversation with some general advice: When building your retirement system, be sure to have a plan and a commitment to success, and make sure you understand the rules before making financial decisions that could have an adverse impact on your strategy.

Folks, as I explained to June and David, IRAs have become essential tools for many of us saving for retirement, so it’s important now more than ever to understand how to use them—as well as how not to use them. Consult a trusted financial professional to develop a retirement strategy that helps provide a steady income throughout retirement, one that allows your savings to grow while preserving capital. Use your IRAs and other financial tools to help your money work for you.

Be vigilant and stay alert, because you deserve more.

Have a great week!

Jeff Cutter, CPA/PFS is president of Cutter Financial Group, LLC, an SEC-Registered Investment Advisor with offices in Falmouth, Duxbury, Mansfield and Southlake, Texas. He can be reached at jeff@cutterfinancialgroup.com.This article is intended to provide general information. It is not intended to offer or deliver investment advice in any way. Information regarding investment services is provided solely to gain a better understanding of the subject or the article. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy will be profitable. Market data and other cited or linked-to content in this article is based on generally available information and is believed to be reliable. Cutter Financial does not guarantee the performance of any investment or the accuracy of the information contained in this article. Insurance instruments offered through CutterInsure, Inc. 1. ICI Frequently Asked Questions About Individual Retirement Accounts (IRAs).

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