Does Cashing in My IRA Affect My Tax Bracket?

Does Cashing in My IRA Affect My Tax Bracket?
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You can get your money out of your individual retirement account whenever you want. Uncle Sam discourages early withdrawals, however, by imposing a 10 percent penalty on the taxable portion of the distribution. Depending on the type of IRA and type of distribution you're taking, cashing in your IRA could increase your taxable income, which might push you into a higher tax bracket.

Traditional IRA Cashouts

When you cash out from your traditional IRA, the whole thing counts as taxable income unless you've put in nondeductible contributions. If you have, you get the nondeductible contributions out tax-free, but the rest of the amount comes out as taxable income. If you're not cashing out the entire balance, you can't pick and choose which parts you want to withdraw first. Instead, you prorate your distribution between the nondeductible contributions and the remainder of the account. For example, if 8 percent of your traditional IRA value is from nondeductible contributions, 8 percent of your distribution is tax-free, and that portion would not push you into a higher tax bracket.

Roth IRA

Roth IRAs, on the other hand, might not increase your taxable income and tax bracket when you take money out. First, if you can take a qualified withdrawal, all the money comes out tax-free. To do so, your Roth IRA must be five years old and you must be 59 1/2, suffering from a permanent disability or taking out no more than $10,000 for a first home purchase. Even if you don't qualify, you can still take out all your contributions tax-free and penalty-free. However, after you've drained your Roth IRA of all your contributions, you start taking out earnings, which do count as taxable income if you're not taking a qualified withdrawal.

Type of Income

The taxable portion of the money you receive from cashing in your IRA always counts as ordinary income for tax purposes. Even if you invested the money in stocks that you held for at least one year, or other assets that would result in long-term capital gains if they weren't in your IRA, you must count the money as ordinary income. You can't take advantage of the lower long-term capital gains rates.

Tax Bracket Math

Your tax bracket refers only to the rate that applies to the last dollar of your taxable income. Since the U.S. uses a progressive income tax structure, you don't pay the same rate on all of your income. For example, say you fall in the 15 percent tax bracket and that you're $5,000 below the 25 percent bracket without including your IRA distribution. If $8,000 of your IRA distribution is taxable, the first $5,000 is taxed at 15 percent because it's still in the 15 percent bracket. Only the last $3,000 is taxed at the higher 25 percent rate. So, even though you're now in the 25 percent bracket, you're only paying that higher rate on a small amount of your income.