Tax rules surrounding individual retirement accounts (IRAs) can be complex. While advisors generally understand them well, clients should familiarize themselves with them to prevent potential issues with their retirement savings.
Withdrawals from an Individual Retirement Account (IRA) are generally subject to income tax as regular income unless an exemption applies; this rule also applies to nondeductible contributions and earnings.
Contributions
Many people assume that contributing to an IRA will help lower their tax bills, which is true in certain instances but not always. First of all, only those earning earned income in the current year (typically salary or self-employment earnings or investment income) are eligible to make contributions.
If you made any nondeductible contributions to a traditional IRA, any distributions that you take from it will be taxed based on their proportional ratio with regards to your total balance in your account – this is known as your basis.
At age 70 1/2, IRA owners must take required minimum distributions (RMDs). RMDs may be tax-exempt depending on whether you qualify for the five-year rule; to maximize savings and minimize taxes and penalties when moving funds between accounts use direct trustee-to-trustee transfers as much as possible.
Earnings
When withdrawing money from an IRA, any realized gains are subject to taxes as ordinary income; Roth IRA withdrawals, in contrast, are tax-free; however a 10% penalty applies if any withdrawal occurs prior to age 59 1/2.
Realized gains do not trigger tax events in an IRA account unless they’re invested in prohibited investments such as collectibles (artwork, antiques, gems and coins, etc). A trustee-to-trustee transfer is another effective way of avoiding creating a taxable event because it leaves an audit trail behind it.
When receiving your IRA distribution report in early 2022, pay attention to Form 1099-R. It will provide information regarding the total amount of your taxable distributions, how much was withheld as prepayment tax and qualified charitable distributions. You’ll need this data when filing your tax return; this is also used by the IRS to calculate what amount they owe upon retirement.
Withdrawals
IRA withdrawals are taxed like other income, with some exceptions. Individuals who hold an IRA may withdraw funds without penalty before age 59 1/2 to cover medical expenses that exceed 7.5% of adjusted gross income, purchase their first home (up to a lifetime limit of $10,000) or pay qualified higher education costs for themselves or family members.
An IRA rollover can also be done without incurring taxes or penalties, provided that it takes place within 60 days; otherwise you’ll owe ordinary taxes on its amount.
Seniors aged 73 or over may also make tax-free withdrawals from their IRAs to support specific charitable causes that comply with IRS rules for qualified charitable distributions, especially beneficial to high-income individuals who would face an enormous tax bill upon withdrawing.
Taxes
IRAs offer tax benefits that allow you to save more for retirement, including contributions that reduce taxable income and investments not subject to federal taxes until withdrawal at retirement age.
Simplified Employee Pension (SEP) IRAs allow self-employed workers and small business owners to set up retirement savings plans for themselves and any eligible employees of their company. Unlike Traditional or Roth IRAs, however, distributions from SEP IRAs are fully taxable upon distributions taking place.
Withdrawals made before age 59 1/2 typically incur a 10% penalty plus ordinary income tax on amounts attributable to previously tax-deducted contributions and earnings, but beneficiaries can avoid this tax in certain circumstances such as unreimbursed medical costs, first-time home purchase expenses or qualified higher education expenses. Additional IRS forms may need to be filed depending on individual circumstances – please see our 2023 IRA Distribution Reporting: IRS Form 1099-R article for further guidance.
