Taxes on Traditional IRA Withdrawals
Traditional IRAs provide greater investment flexibility and tax benefits compared to employer-sponsored plans, yet it’s essential that you understand all of their rules before withdrawing money from one.
Roth and traditional IRA contributions withdrawn early are tax-free if done in accordance with applicable rules, while earnings withdrawals before age 59 1/2 could trigger taxes and penalties.
1. No nondeductible contributions.
Nondeductible contributions offer an alternative for people who do not meet the requirements to make tax-deferred contributions to traditional IRAs, yet still want tax-free growth and withdrawals in retirement without incurring taxes.
Your contributions to nondeductible accounts depend on both your income and employer-sponsored retirement plans; eligibility to contribute may also phase out at certain income thresholds depending on filing status and modified adjusted gross income limits.
Maintaining your after-tax basis when making nondeductible contributions to an IRA is especially crucial if you intend to withdraw them tax free at some point in the future, since you must report all such contributions using Form 8606. When withdrawing money from an IRA, basis withdrawals don’t incur income taxes whereas withdrawals of deductible contributions and account earnings do incur income tax liability. By not accurately reporting nondeductible IRA contributions you risk forfeiting step up in basis that typically applies when beneficiaries sell appreciated investments held within traditional IRAs when beneficiaries sell appreciated assets from traditional IRAs when beneficiaries sell appreciated investments held within traditional IRAs.
2. No Roth IRA.
Traditional IRA withdrawals are tax-free as long as contributions remain distinct from earnings. However, if you take withdrawals before age 59 1/2 and dip into earnings rather than contributions you’ll incur income taxes and possibly an early withdrawal penalty of 10% as well.
As is often the case, following all applicable rules will help you avoid penalties. For instance, taking what’s known as a 72(t) distribution prior to turning 59 1/2 and fulfilling specific requirements will let you sidestep them altogether.
Roth IRA rules can be more complex. In order to withdraw investment earnings tax-free from your Roth account after five years of holding it open, this rule sets them apart from traditional retirement accounts like 401(k)s that require withdrawals starting at age 70 1/2.
3. No first-time homebuyer exception.
Traditional IRA withdrawals are treated as taxable income and, typically, incur an early withdrawal penalty of 10% from the IRS; unless an exception applies. Your tax advisor can explain any such situations that qualify for exceptions.
Owners of individual retirement accounts (IRAs) can withdraw up to $10,000 without incurring a penalty if the money is used towards purchasing their first home within 120 days after distribution from an IRA account. This rule only applies to IRAs; other types of retirement plans like 401(k) plans or self-employed plans like SEP and SIMPLE IRAs do not fall under this provision.
Beneficiaries of an inherited IRA can avoid an early withdrawal penalty by taking distributions to cover higher education expenses for themselves, their spouses, children or grandchildren. Eligible expenses include tuition fees, books and supplies (tuition included for half time students attending at least half time school); room and board may qualify if attending school at least half time. Because tax rules can be complicated, please seek the advice of a tax professional when taking distributions for these purposes. An IRS Form 8606 must also be completed by beneficiaries to report how much of each distribution came from contributions, conversions or earnings sources.
4. No unemployment compensation exception.
IRS rules regarding IRA withdrawals generally don’t take unemployment into account when dispensing distributions; however, some owners can receive tax-free distributions to cover health insurance expenses related to periods of unemployment.
Your IRA custodian must withhold federal income tax at a rate of 10 percent from each distribution made from your account; you’ll owe this payment when filing your return for the year of receiving withdrawals.
Withdrawals from Traditional, SEP and SIMPLE IRAs are treated identically for purposes of calculating tax liability. Each withdrawal consists of a pro rata split between basis assets and taxable assets based on your total traditional, SEP and SIMPLE IRA balances as well as any inherited accounts that you inherit. Before making any major decisions with your retirement savings it’s a good idea to consult with a financial advisor; SmartAsset offers free advisor matching tools that connect users to professionals serving in their area