Do You Pay Income Tax on IRA Withdrawals?
A: In general, withdrawals from an individual retirement account (IRA) should be included as income in gross income calculations. There may be exceptions such as distributions made under a domestic relations order or to cover medical expenses.
Tax treatment of IRA withdrawals will depend on their type, age and contribution history as well as on accurate tracking and selecting appropriate withdrawal methods.
Taxes on IRA withdrawals
Taxes payable when withdrawing funds from an IRA depend on several factors, including its type, age and purpose of withdrawals. Sometimes this means paying nothing at all; other times however, you could owe income tax as well as potential penalties depending on individual circumstances.
For instance, withdrawing funds from an IRA before turning 59 1/2 will count as regular income and may be subject to a 10% federal penalty tax, unless an exception applies. This rule applies equally for traditional and Roth IRAs.
Assuming you take a distribution from your IRA prior to age 59 1/2 in order to purchase your first home or pay health insurance after losing your job, exceptions do apply if this money is used towards buying that first house or paying medical expenses associated with being jobless. There may also be restrictions if the distributions are used towards paying a divorce settlement or satisfying requirements set out in a court-ordered separation agreement.
As soon as you make a withdrawal from an IRA, the funds must be reported on your tax return. Your trustee or custodian should send Form 1099-R with all the withdrawal information.
Taxes on Roth IRA withdrawals
Roth IRAs offer retirees an appealing tax break by providing tax-free retirement income provided certain criteria are met. If earnings from your Roth IRA are withdrawn before meeting those criteria, however, income taxes and an early withdrawal penalty of 10% will apply.
Financial advisors frequently ask their clients if they expect to be in a higher or lower tax bracket in retirement than now, in order to help determine whether a traditional or Roth IRA might make more sense for them.
Roth IRAs offer tax-free money for your heirs without penalties or taxes owed, which makes them attractive investments. But one drawback of inheriting one may be its five-year clock, which begins once you convert from traditional to Roth, and doesn’t stop until qualified distribution requirements have been fulfilled.
Taxes on Traditional IRA withdrawals
Traditional IRA contributions may be eligible for tax deduction, with earnings growing tax-deferred until withdrawal. Withdrawals are taxed as ordinary income; any early withdrawals before age 59 1/2 incur an additional 10% penalty tax.
IRS law mandates that your IRA custodian withhold federal income tax on any withdrawal you make, unless you waive it or elect for less withholding. Any withheld amounts should be reported on Line 4a of Form 1040 when filing next year’s return.
Don’t forget to count all nondeductible IRA contributions, such as those made to SIMPLE- and SEP-IRAs established for small businesses or self-employed individuals, when filing your taxes. And if you inherit an IRA, be aware that withdrawals must also be reported; though the IRS audits only a very low percentage of returns so there should be little risk involved by failing to do so.
Taxes on Rollovers
Rollovers involve moving money from an employer-sponsored retirement account (such as a 401(k) or SIMPLE-IRA) into an individual retirement account (IRA), as well as between trustees of an IRA. While the one-rollover-per-year rule doesn’t apply to such transfers, before initiating one you must determine its tax implications and figure out your taxable portion before proceeding with any rollover transactions.
No matter if it is direct or indirect, any distribution must reach the new IRA provider within 60 days or it becomes taxable and could trigger the 10% early withdrawal penalty.
Every eligible rollover distribution you receive may be subject to income tax withholding at an approximate rate of 20%, however you can reduce or even eliminate this withholding by providing your payer (such as plan administrator or bank) with Form W-4R: Withholding Certificate for Nonperiodic Payments and Eligible Rollover Distributions. Furthermore, using this form allows you to request higher withholding.