Taxes on Individual Retirement Accounts (IRAs)

An individual retirement account (IRA) is an excellent tool for saving and investing for retirement. Learn how its tax rules operate with this flexible savings option.

IRAs can be obtained from many providers, such as brokerage firms, banks and credit unions. They can take the form of cash instruments like savings accounts or certificates of deposit; or investments like ETFs mutual funds and stocks.

Taxes on Distributions

Traditional IRA withdrawals are subject to tax at ordinary income rates that depend on your tax bracket, while Roth IRAs permit penalty-free withdrawals under certain conditions.

Nondeductible contributions create tax basis in your IRAs, so each year it’s necessary to determine how much of your withdrawals come from tax-free basis and how much is subject to taxes. For this, use a fraction with numerator equaling cumulative nondeductible contributions across all your IRAs, and denominator as total account balance as of end-year plus withdrawals during that year.

If you withdraw funds from your IRA before age 59 1/2, they will incur a 10% penalty tax, with certain exceptions such as unreimbursed medical expenses exceeding 7.5% of adjusted gross income or health insurance premiums for self-employed. Furthermore, individuals aged 73 or over must take required minimum distributions (RMDs), which also incur tax liability.

Taxes on Rollovers

Many people can find themselves having difficulty keeping track of all the various details involved with IRAs, especially when dealing with rollovers from a 401(k) plan to an IRA or another retirement account. To safely implement such transfers, ask for a trustee-to-trustee transfer (also called direct rollover). However, follow up after depositing to ensure the check was deposited properly – some firms make mistakes when depositing checks that could incur taxes as a result.

As part of your 401(k) distribution, 20% may be withheld to cover federal taxes. Check your 1099-R to determine its total distribution value; if an amount appears in Box 2a indicating withheld taxes was deducted, all of that money must be placed directly into an IRA in order to avoid being taxed again.

Taxes on Direct Transfers

If you withdraw funds from your IRA and deposit them back within 60 days, no taxes are owed on those funds. Furthermore, direct transfers or “trustee-to-trustee” rollovers can help transfer them without creating any taxable events; these must be documented properly as they contain certain restrictions.

Rollovers must be handled by the administrator of the new plan, who issues a check payable to your IRA custodian. If you handle it yourself, however, this counts as a taxable withdrawal and could trigger an extra 10% penalty if you’re under age 59 1/2.

Your IRA administrator should send you Form 1099-R detailing distributions. If for some reason this form does not arrive or an IRA withdrawal was missed off of your tax return, filing an amended return can help rectify this. A tax advisor can assist with calculating how to include this amount on an amended return.

Taxes on Inherited IRAs

An IRA beneficiary has several options when it comes to managing their inheritance, including disclaiming, rolling over into their own account or taking required minimum distributions (RMDs). All options carry potential tax ramifications.

If an heir fails to take their RMDs on time, they could face a 50 percent penalty fee – it is therefore essential for beneficiaries to check with their custodian to ensure all information is updated accurately in their records.

Inherited IRAs must follow the IRS RMD schedule, meaning withdrawals should be taken within five years after their original owner passes away. If their original account holder died prior to turning 70.5, their heir can use the 5-year rule instead, spreading withdrawals over their lifetime. Alternatively, they have the option of taking ownership (known as spousal transfer) by renaming themselves on the account in their own name; this allows contributions to continue but their first distribution must occur by 31st December following their spouse’s passing.