Individual retirement accounts (IRAs) are a common way for individuals to save for retirement. These accounts are structured in a way that follows strict guidelines about withdrawals, which are also known as distributions. IRA withdrawals can be subject to federal tax and, in some cases, withdrawals may also be assigned penalties for non-qualified distributions. States may tax retirement distributions as well, so it is important to be aware of the state policies that may apply regarding the taxation of IRA withdrawals.
What Are the Basic Rules for IRA Withdrawals?
IRA accounts have many rules regarding contributions and distributions that can catch some people by surprise, especially when it comes to penalties. The basic rules are that most qualified withdrawals from a traditional IRA must be made by the account holder between the ages of 59 1/2 and 72. After age 72, required minimum distributions must be taken or a 50 percent penalty will be assigned.
Roth IRAs do not have a required minimum distribution. If a non-qualified withdrawal is made from an IRA, such as the owner is not yet 59 1/2, a 10 percent penalty will be applied in addition to any taxes owed.
Certain early withdrawals can avoid taxation, such as to fund higher education or to purchase a house – but only up to a lifetime amount of $10,000. Converted Roth IRAs are also subject to the five-year rule for withdrawals and are distributed based on a first-in, first-out basis. Traditional IRA distributions must be included on a tax return, while non-taxable, qualified Roth distributions may not have to be included on a tax return. Traditional IRA distributions may also affect whether Social Security benefits are taxable as well.
The CARES Act response to the coronavirus changed a lot of the rules regarding IRA distributions for the 2020 tax year. Required minimum distributions were waived. IRA withdrawals to deal with hardship due to coronavirus are considered qualified and recontributions are not subject to regular annual limits. The IRS has listed all of the changes impacting retirement distributions resulting from the CARES Act on its website.
Which Parts of an IRA Withdrawal Are Taxable?
IRAs are taxed based on whether contributions were tax-deductible. Deductible contributions are tax-deferred, meaning the tax is paid later at withdrawal. Nondeductible contributions are tax-exempt, which means the tax is paid upfront and not subject to further taxation.
Traditional IRA contributions are mostly tax-deductible, meaning that the contribution was excluded from income tax when it was placed into the account. Traditional IRAs are taxed based on contributions and are also taxed on earnings. Roth IRA contributions are taxed before being placed into the account. Roth contributions and earnings are not taxed upon withdrawal if the account has been active for five years and the account holder is at least 59 1/2 years old.
Traditional IRAs can also be converted to Roth accounts, but those are taxed upon conversion. Since Roth accounts are funded with post-tax money, contributions can be withdrawn at any time, but non-qualified withdrawals on earnings are subject to a 10 percent penalty. Roth IRA withdrawals from an account that is less than five years old will be assessed tax on withdrawals until the five-year limit is met. Taxes on IRA withdrawals can be withheld at the time of withdrawal, paid at tax time (which may be subject to penalty) or paid through estimated payments.
How to Calculate Tax on an IRA Withdrawal
Traditional IRA withdrawals are taxed as ordinary income. This means that the amount of tax is based on income brackets. Often, this does not change from year to year, so the rate of tax on distributions will usually be the same as last year's tax rate. It is essential to know the amount of required minimum distribution that must be withdrawn from an IRA, as not taking this amount can result in steep penalties. The IRS Required Minimum Distribution Worksheet can be used to calculate the amount that must be distributed.
If the account was funded entirely with deductible income, then the entire amount of the withdrawal will be taxable. It is important to know how much of the account has been funded with nondeductible contributions, because nondeductible contributions are not taxable upon withdrawal. For traditional IRAs, nondeductible contributions are recorded to the IRS on a tax return for the tax year of contribution on Form 8606.
If there are both deductible and nondeductible traditional IRA contributions, divide the amount from deductible contributions by the current account value. Next, take that number and subtract it by one to get the taxable amount of a withdrawal. Finally, multiply the taxable amount by the amount of the withdrawal.
Consider an Example
For example, if there is $100,000 in a traditional IRA and $10,000 of that amount was from nondeductible contributions, first, divide the $10,000 by $100,000 for a result of 0.10. Next, subtract 0.10 from 1, for a total of 0.90, which is the taxable portion of the withdrawal. If the withdrawal amount is $10,000, multiply the withdrawal amount of $10,000 by 0.90 for a total of $9,000.
In this example, $9,000 of the withdrawal would be taxable. Apply the applicable tax rate plus any penalty to the taxable portion of the withdrawal to calculate the amount that will be owed.
- H&R Block: Traditional & Roth IRAs: Withdrawal Rules and Early Withdrawal Penalties
- Charles Schwab: Roth IRA Withdrawal Rules
- Charles Schwab: IRA Withdrawals and Distributions
- AARP: 12 States That Won't Tax Your Retirement Distributions
- IRS: Coronavirus Relief for Retirement Plans and IRAs
- The Motley Fool: Does an IRA Distribution Count As Income to Social Security?
- Kiplinger: How to Calculate Tax-Free and Taxable IRA Withdrawals
- How to Calculate the Taxable Amount of an IRA Withdrawal
Hashaw Elkins is a financial services and tax professional, as well as a project management consultant. She has led projects across multiple industries and sectors, ranging from the Fortune Global 500 to international nongovernmental organizations. Hashaw holds an MBA in Real Estate and an MSci in Project Management. She is further certified in organizational change management, diversity management, and cross-cultural mediation.