How Much Tax Do I Pay on an IRA Withdrawal?
An IRA withdrawal is subject to taxes; how much depends on its type, age and whether any special provisions exist. Your tax advisor can assist in understanding these rules.
First-time home buyers can access up to $10,000 penalty-free from their IRAs for use towards purchasing their first home, both traditional and Roth accounts are covered under this rule.
Taxes
If you withdraw money from an IRA before turning age 59 1/2, the IRS will typically consider that withdrawal part of your income and add an additional 10% penalty tax unless an exception applies – since traditional retirement accounts use pre-tax money when funding them.
When withdrawing funds from an IRA for unreimbursed medical expenses that exceed 7.5% of adjusted gross income or to purchase your first home, the IRS treats these withdrawals as qualified expenses. But if they’re used for any other reason – living expenses or debt payments, for instance – then regular tax bills may apply.
Avoiding taxable withdrawals with an IRA by taking advantage of its 60-day grace period when redepositing its funds into another account without incurring taxes, but note you can only do it once each year. In addition, be mindful not to overstate its basis as the IRS could penalize you $50 if filing Form 8606 when required and $100 for overstating its basis without reasonable cause.
Penalties
the IRS typically taxes withdrawals from Traditional, SEP and SIMPLE IRAs as ordinary income. Your exact taxable portion depends on both your age and amount withdrawn; each distribution includes part of both nondeductible contributions (known as basis) and earnings that are taxable; Form 8606 can help calculate this figure.
Withdrawals from Roth IRAs are tax-free, but their withdrawal rules differ considerably from traditional IRAs. You must begin taking minimum distributions by age 73 or face steep penalties.
Early withdrawal penalties do have some exceptions, including higher education expenses, unreimbursed medical expenses that exceed 7.5% of adjusted gross income and first-time home purchases. A bill in Congress would expand this list further to include victims of domestic abuse and terminal illnesses. If unsure whether you qualify, consult your financial professional and/or CPA/tax attorney for guidance and advice.
Exceptions
Penalties for withdrawing funds early from an individual retirement account before age 59 1/2 can be severe; however, there are exceptions. First-time home buyers can withdraw up to $10,000 penalty-free when using it towards “qualified acquisition costs,” including purchasing, building or rebuilding a house as well as the associated settlement, financing and closing costs.
Under another exemption, withdrawals without penalty can be made if your out-of-pocket medical expenses surpass 7.5% of your adjusted gross income and must be paid within the same year that your withdrawal takes place.
Your IRA distributions can also avoid the 10% penalty by being made based on your life expectancy or one of three approved methods; these payments are known as substantial equal periodic payments (SEPPs). A new law passed by Congress, known as SECURE 2.0, also permits penalty-free withdrawals should you need money due to unexpected medical or housing costs from disaster.
Tax-Free Withdrawals
At age 59 1/2 or later, withdrawals of earnings from an IRA should generally be tax-free; whether or not taxes apply will depend on whether contributions were included as part of your withdrawal amount or whether your withdrawal consists of earnings only.
Your IRA allows for penalty-free withdrawals to pay for certain medical expenses or purchase your first home, though these withdrawals have an annual maximum withdrawal limit of $10,000.
To determine your tax-free basis, it’s necessary to use a formula which divides the sum of all your nondeductible contributions by an annuity factor derived from an IRS life expectancy table and “reasonable” interest rates; then multiply this figure by your withdrawal amount.
An IRA withdrawal could potentially be made penalty free if used to pay for employer-sponsored group health insurance following job loss, however you should check with your employer first regarding any requirements you must fulfill to be eligible for this exemption and report any distributions on your return.
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