How Much Tax Do I Pay on an IRA Withdrawal After Retirement?
Savers typically incur a 10% penalty tax when withdrawing money from qualified retirement accounts such as an IRA or workplace plans such as 401(k) before age 59 1/2. There may be exceptions to this rule, however.
No matter the nature of your withdrawal, it’s crucial to understand how much tax will be due so as to plan appropriately and prevent any unpleasant surprises later on.
Taxes on IRA withdrawals
Contributions made before taxes are deducted are tax-deferred until withdrawal. When a taxpayer reaches age 59 and a half, regular distributions must begin or face penalties from their IRA administrator.
IRA withdrawals are generally subject to income taxes unless they fall into one of the IRS-approved exceptions (e.g. first home purchase or education expenses). Furthermore, any withdrawal taken before age 59 and six months will incur an extra 10% early distribution penalty tax.
Every year, it is your responsibility to determine your taxable amount by creating a fraction with the numerator being all nondeductible contributions to traditional IRAs and denominator being the total balances in all your accounts as of December 31. Withdrawals should then be multiplied by this fraction in order to arrive at your taxable total. Once this calculation has been made, Form 5329: Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts is filed so as to report this figure and pay any applicable taxes due.
Taxes on Roth IRA withdrawals
Roth IRA withdrawals typically are tax- and penalty-free. However, if investment earnings are withdrawn before age 59 1/2 and don’t meet the five-year holding period rule, then the IRS taxes the earnings portion.
Example: Assuming someone contributed $2,000 to a Roth account in 2022 and invested it for seven years before withdrawing all $7,500 at age 63, income taxes will apply only on earnings exceeding the first five-year threshold of earnings from this account.
Avoiding the penalty when withdrawing funds can be achieved if you’re an eligible first-time home buyer, disabled individual with high medical expenses, paying funeral costs for someone close to you or rolling it over to another qualified IRA like traditional or Roth. Transferring from trustee-to-trustee is required for this transaction – either directly by you or using a custodial or brokerage account.
Taxes on Traditional IRA withdrawals
Once you start withdrawing money from a traditional IRA after retirement, income tax must be withheld from withdrawals; however, you can avoid a 10% early withdrawal penalty by waiting to distribute until age 59 1/2.
Avoiding the penalty can also be done if you make nondeductible contributions or qualify for charitable withdrawals, military service, medical bills and college expenses for yourself or your children are exempt.
Calculating taxable withdrawals requires using either the annuitization or amortization methods, followed by switching to either of the required minimum distribution (RMD) methods in later years. A one-time change to either method is permitted; any further modifications could incur additional taxes. You can find more information on calculating taxes in IRS Publication 590.
Taxes on In-Kind Distributions
When withdrawing funds from taxable investments and traditional IRAs (and some other tax-deferred accounts), federal income taxes must be withheld on these distributions. By contrast, when withdrawing them from Roth IRAs or qualified plan accounts containing pretax or tax-deductible contributions you pay no federal income taxes at withdrawal time.
Understanding how different assets are taxed is vital when devising a sensible order for withdrawing your retirement accounts, according to Greenberg. He suggests tapping taxable assets first before moving onto tax-deferred and eventually tax-free retirement assets.
Required minimum distributions allow required minimum distributors to make one-time changes to their calculation method for RMD payments. For instance, switching from amortization/annuitization to required minimum distribution after beginning your series will ensure future RMDs won’t incur the 10% early withdrawal penalty.