Many Americans save for retirement in individual retirement accounts (IRAs). Withdrawals from an IRA are generally subject to taxes; however, certain exceptions exist and those taking withdrawals before age 59 1/2 must pay an additional 10% tax penalty.
Taxability of an IRA withdrawal depends on both its deductible contributions and its intended use; exceptions include using it for education expenses or purchasing your first home.
Taxes on IRA Withdrawals
Money you invest in an IRA is tax deductible; each dollar contributed reduces your taxable income for that year, but earnings on those investments won’t be taxed until they’re withdrawn at retirement time.
To determine how much of an IRA withdrawal is taxable for that year, a calculation using your age, type of account and accurate tracking is used to arrive at an amount payable in taxes.
Some IRA withdrawals may be excluded from your taxes by making direct donations to qualified charities, known as Qualified Charitable Distributions (QCDs). There may be limitations on the amount you can contribute and whether the exclusion can apply – for more information and guidance please speak with your tax advisor.
Taxes on Roth IRA Withdrawals
Traditional IRA withdrawals typically incur taxes and penalties; Roth IRA distributions don’t. But that doesn’t mean all Roth withdrawals are tax-free.
If you withdraw investment earnings from a Roth account before age 59 1/2, they’re subject to income taxes as well as an early-withdrawal penalty of 10%; this penalty may be waived in certain situations such as taking out qualified distributions.
Qualified withdrawals could include purchasing your first home; paying unreimbursed medical expenses exceeding 7.5% of adjusted gross income annually; using funds for health insurance premiums while unemployed; taking substantially equal payments over your lifetime; becoming disabled Reservist or passing away.
Other exceptions may apply, too; but if you are under 59 1/2, withdrawals from your Roth IRA earnings should generally be avoided until it’s certain that one or more exceptions applies in your particular situation. Otherwise, extra taxes and penalties could dramatically deplete your nest egg.
Taxes on Traditional IRA Withdrawals
Traditional IRA withdrawals are treated as ordinary income because the IRS exchanges a tax break now for after-tax money when withdrawing contributions and earnings later on.
With some exceptions, IRA funds can be used for things such as purchasing your first home, education costs for yourself or family, medical bills and certain disability expenses. Any withdrawals before age 59 1/2 typically incur a 10% penalty fee.
Once you reach a certain age, required minimum distributions (RMDs) from your Traditional IRA and any other retirement accounts you own must begin being taken automatically. Your RMD is calculated each year by dividing your prior year-end total balance by your life expectancy as shown in Appendix B of IRS Publication 590-B tables; failing to take these RMDs could incur severe excise taxes from the IRS imposed by Form 1099-R that your custodian or trustee typically sends directly.
Taxes on RMD Withdrawals
If you are age 70 and a half or over, annual required minimum distributions (RMDs) from your traditional and Roth IRAs as well as 401(k), 403(b), and 457(b) accounts must be taken. RMDs can be calculated by dividing your year-end balance by the IRS life expectancy factor as found in Publication 590-B tables.
Denominators decrease as you age, increasing your RMD amounts every year. Congress established RMD rules in order to avoid people accruing tax-deferred retirement accounts that then become fully taxable after years of not making contributions.
There are various strategies available to you in order to reduce RMD taxes, such as shifting your RMD amount from your IRA into a taxable brokerage account and depending on the value of shares at transfer date, this could reduce what’s subject to income tax. You could also try taking nondeductible contributions into consideration.