Tax rules surrounding Individual Retirement Accounts (IRAs) can be complex. When withdrawing funds before age 59 1/2, ordinary income taxes and possible penalties of 10% apply.
However, there are a few strategies available for avoiding early withdrawal penalties that should be understood.
Taxes on IRA Withdrawals
Your 2022 IRA withdrawals could incur taxes depending on their type and purpose. Taxable amounts could differ significantly if nondeductible contributions have been made.
If you withdraw money from a traditional or SEP IRA prior to reaching age 59 1/2, unless exempted by the IRS, a 10% penalty tax may apply. Some examples include medical expenses exceeding 7.5% of adjusted gross income or first-time home purchases – your financial advisor can assist in understanding which exemptions may apply to you.
Taxes should also be considered when withdrawing funds from Roth accounts funded with after-tax money. To calculate their tax-free basis, Roth account holders need to divide cumulative nondeductible contribution amount by your total account balance as of year-end – this gives us our IRA’s current value and denominator as our fraction divider.
Taxes on Roth IRA Withdrawals
Money you deposit into a Roth IRA is tax-deferred, so it won’t impact your income tax rate in the year it’s contributed. Any investment earnings that accumulate are subject to taxes when they’re withdrawn in retirement; whether this incurs additional taxes is dependent upon several factors including initial investment amount and timing.
Your IRA allows for penalty-free withdrawals if they’re needed for medical expenses or unemployment insurance costs, purchasing or building your first home, qualified education expenses or emergencies such as natural disaster-related repairs.
IRS charges an extra 10 percent tax on withdrawals made from Roth accounts that don’t meet qualifications for qualified expenses. You can avoid this tax by not withdrawing before reaching age 59 1/2 and adhering to certain other rules.
Taxes on Traditional IRA Withdrawals
If you have not made nondeductible contributions to a traditional IRA, all withdrawals from that account are fully taxable and must be included as income for the year in which they were taken. An early withdrawal penalty tax of 10% usually applies for distributions taken prior to age 59 1/2; your tax advisor can help determine if there are any exceptions that apply.
Withdrawals are subject to tax at your current marginal tax rate, so any income earned through withdrawal must be reported on IRS Form 1040 along with all sources of income received in the year in which they occur.
Traditional IRAs permit you to make after-tax contributions, and typically provide lower taxes when withdrawing in a lower tax bracket. A Roth IRA may be more suitable for people expecting to enter higher income tax brackets when they retire.
Taxes on Rollovers
Rollovers allow investors to avoid early withdrawal penalties and keep funds tax-deferred for as long as possible, yet can sometimes catch people by surprise. But be wary! There may be hidden costs involved that could put your finances in jeopardy.
If the amount withheld from you isn’t deposited within 60 days – even one day late!- then it counts as a taxable distribution and you will incur the 10% penalty. You are also only allowed one IRA-to-IRA rollover per year.
There are specific rules surrounding inherited IRAs that beneficiaries need to keep in mind; otherwise they could find themselves owing taxes upon withdrawals from them. Therefore, it would be prudent for beneficiaries to consult a financial advisor prior to withdrawing money in order to plan ahead for possible tax repercussions and avoid surprises when withdrawing money from an inherited IRA. Taking the necessary steps will help guarantee your retirement savings are there when needed – an objective worth striving for!
