Who Pays Taxes on IRA Distributions?
An Individual Retirement Account, or IRA, can be an essential component of your retirement planning strategy; however, you must understand its tax ramifications before making decisions involving it.
Contributions to an Individual Retirement Account are tax deductible depending on your income, filing status and whether or not your employer offers retirement plans for you to contribute. Withdrawals are treated as regular income with an early withdrawal penalty of 10% applied.
Contributions
Traditional, SEP or SIMPLE IRAs allow you to contribute pretax money that grows tax deferred until withdrawals. Any withdrawals before age 59 1/2 will be taxed as current income; there may be exceptions if used for unreimbursed medical expenses, first home purchases or higher education expenses.
A non-deductible IRA allows you to contribute only if you earn earned income, such as from your employer or through self-employment. The IRS limits how much money can be contributed each year as your income rises; so your contributions may decrease over time as income rises.
If you inherit an IRA from someone over 73, required minimum distributions (RMDs) must be taken annually and taxed as ordinary income. If they are disabled or chronically ill, however, RMDs may be adjusted depending on life expectancy instead of regular RMDs based on your lifetime total amount received from them – however a trusted financial advisor or tax attorney can guide you on ways to minimize being forced into higher tax brackets when receiving this inheritance.
Withdrawals
In general, withdrawals from an IRA will incur taxes when taken before turning age 59 1/2. Your tax obligation depends on whether your contributions were tax deductible and any earnings that haven’t yet been taxed become taxable as ordinary income in the year of withdrawal.
If you withdraw funds from a traditional or SEP IRA before age 59 1/2, they must be added to your taxable income and may incur an early withdrawal penalty of 10% unless there are specific exceptions. Financial planners generally advise leaving nondeductible contributions in an IRA until you reach retirement age to avoid incurring these additional taxes and penalties.
If you leave an IRA to a non-spouse, required minimum distributions must begin no later than April 1 of the year following your 70 1/2 birthday. Any amounts taken in those first 10 years could nudge them into higher tax brackets; due to SECURE Act 2019, RMD age has been raised from 70 1/2 to 72 for those born after 2019. Walter leaves $1 Million of his IRA with his trustee, who then distributes it amongst A and B as per Walter’s wishes.
Rollovers
When moving retirement assets from an old employer’s plan to an IRA, the IRS considers this distribution and taxes must be paid. When possible, direct transfers should be used; that way, your former plan sends them directly to your new IRA trustee, eliminating tax complications altogether.
However, if you implement a rollover and your old plan sends you a check to forward to your new IRA provider, then this payment must be included as income on your 1040X amended return for that year.
If you withdraw money from your IRA before age 59 1/2, withdrawals are subject to ordinary income taxes and a 10% penalty. Withdrawals made without incurring this taxation typically qualify for penalty-free withdrawals in cases involving first-time home purchases; medical expenses that exceed 7.5% of adjusted gross income; unreimbursed medical expenses exceeding 7.5% of adjusted gross income; alimony obligations or qualified domestic partnership expenses among others.
Fees
Traditional IRA contributions provide an income tax deduction, thus lowering taxable income in the year of contribution. When withdrawing funds in retirement, however, taxes must be withheld according to regular income rates; additionally if taken out prior to age 59 1/2 they could incur a 10% penalty tax as well.
For non-spouse beneficiaries, the SECURE Act of 2020 raised their required minimum distribution (RMD) age from 70 1/2 to 72 and mandates most inherited IRAs be distributed within 10 years – this represents a drastic change from prior practice when distributions could be spread over an individual’s expected life expectancy.
An RMD is calculated by dividing the prior December 31 balance by an IRS life expectancy factor taken from Publication 590-B table. You should calculate an RMD separately for each IRA owned, though their totals can be added together into one total amount. SEP IRAs allow self-employed individuals and small business owners to contribute on behalf of themselves and their employees without RMD requirements during their lifetimes.
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