The goal of investing is to have your money work for you by earning interest or appreciating in overall value. This is why financial experts recommend investing as a tool for individuals desiring to be financially prepared for the future, especially retirement. Successful investing comes with a price tag in most cases -- tax liability. These liabilities usually are associated with investment withdrawal.
Typically, when you take money out of an investment account such as an IRA, the Internal Revenue Service treats the withdrawal as income and you must pay income tax on the amount withdrawn. The more you withdraw from the investment, the heftier your resulting tax liability is likely to be.
The IRS allows some exceptions to the rule that account withdrawals are subject to income tax. One example is the Roth IRA. With this type of investment account, your contributions are made from after-tax income, which means that when you take a withdrawal, you've already paid the taxes on the money. A tax-deferred investment doesn't eliminate taxes but it does give you some control over when you pay to accommodate your financial plans and needs. Paying taxes up front can be advantageous in retirement when your resources, and your ability to pay taxes, might be more constrained than during years of employment.
The amount of tax liability that may accrue on an investment withdrawal depends on the type of investment account and your age. If you are between the age of 59 ½ and 70 ½, you generally can withdraw money without penalties from retirement accounts such as IRAs. If you withdraw money before this age -- known as a "premature withdrawal" -- the IRS assesses a 10 percent penalty plus regular income tax on the taxable portion of the withdrawal. You also can face penalties in some accounts if you leave the money in the account too long. For example, with an IRA, you must begin withdrawing a minimum amount at least once a year after you reach age 70 ½. The minimum amount is set by the account value and IRS life expectancy charts. If you take less than the minimum, you have to pay a 50 percent penalty on the difference. As an example, if you were required to withdraw $1,000 and you only took out $750, your penalty would be half of $250, or $125. General investments don't have these penalties but may have other fees associated with withdrawal that you need to consider in addition to the income tax requirement.
Liability Reduction Techniques
Even though it is very difficult to completely avoid a tax liability on an investment withdrawal, techniques are available that may reduce the amount you owe. For instance, because the IRS determines the minimum distribution you must take from your IRA after age 70 1/2 using charts for both you and your beneficiaries, choosing a young beneficiary provides a greater combined expectancy and thus reduces the required withdrawal as well as your tax liability. Withdrawing smaller amounts over a longer period also spreads out the liability. Additionally, you may be able to claim tax deductions for contributions to your retirement account. Taking money out of taxable accounts and placing it in a tax-deferred investment is another trick you can use to save on taxes, explains Mary Beth Franklin of Kiplinger.
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