How Can an IRA Affect Your Tax Liability?

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Traditional and Roth Individual Retirement Accounts (IRAs) give you tax breaks to help you save for your golden years. One advantage is that money grows tax-free and doesn’t affect your tax liability as long as it stays in an IRA. However, IRAs are tax-deferred savings plans, meaning you will pay taxes on at least some of your IRA money sooner or later.

Deductible Contributions

Contributions to a traditional IRA are tax-deductible in most cases, so you get to write off the contribution when you do your taxes each year. That reduces your tax liability. The amount you save is equal to your marginal tax rate multiplied by the amount you contribute. A marginal tax rate is the highest percentage of tax you pay on any of your income. For example, if you contribute $5,000 and your marginal rate is 28 percent, you save $1,400. If you or your spouse is covered by a retirement plan at work, you might not get this tax deduction. You can still make nondeductible contributions. However, because you can’t write them off, nondeductible contributions have no effect on your tax liability.

Taxable Distributions

When you withdraw money from a traditional IRA, it is taxable income except for any nondeductible contributions you’ve made. All taxable dollars you take out of a traditional IRA are taxed as ordinary income at your marginal tax rate. Suppose you withdraw $12,000 in a year, all of it is taxable, and your marginal rate is 28 percent. Your tax liability increases by 28 percent of $12,000, or $3,360.

Roth IRAs and Taxes

Roth IRA contributions are not tax deductible, so they have no effect on your tax liability. When you withdraw money from a Roth after the account has been open for five years and you are 59 1/2 years old, it counts as a qualified distribution. This means the money you take out is tax free and so has no impact on your tax liability. Provided the five-year rule is met, distributions are also qualified when you are disabled, the Roth IRA is inherited, or you use the money to fix up or buy a first home, up to a limit of $10,000. If you take out earnings from a Roth IRA, and they are not qualified, you own income tax on the money just as you do for a traditional IRA withdrawal. Roth contributions are not taxable when you take them out because they were already taxed when you deposited them.

Penalty Taxes

The IRS assesses penalties for not following IRA rules that can increase your tax liability. Taking money from an IRA before you are 59 1/2 is called an early distribution, and the IRS tacks on a 10 percent penalty tax unless the reason for the withdrawal qualifies as an exception. If you contribute too much to your IRA, you may have to pay a 6 percent penalty tax. You can avoid this by removing the extra cash by your tax filing deadline, including extensions. Finally, you have to start taking minimum required distributions from a traditional IRA when you reach age 70 1/2. The IRS will hit you with a 50 percent excise tax in addition to income taxes if you don’t take out enough. Roth IRAs have no minimum distribution rule – you don’t have to take the money out until you're ready.