Using an individual retirement account to save for retirement can net you substantial income tax savings. That doesn't mean all withdrawals are exempt from taxes, however, or that federal tax consequences are the same as those at the state level. Whether you empty your IRA or just take out a fraction of the account's value, the rules determining the tax consequences are the same.
Federal Tax Consequences of Roth IRA Withdrawals
If you take a qualified withdrawal from a Roth IRA, you won't pay income tax on the money. But you must be older than 59 1/2 to take a qualified withdrawal and your Roth IRA must be at least five years old. You can get your contributions back without paying any income taxes if you don't meet these criteria, but earnings on the account are taxed. For example, you may be 40 years old, you've put $75,000 in your Roth IRA, and it's now worth $100,000. You can take out $75,000 tax free. But if you take $76,000, the $1,000 that represents your earnings is taxable income.
Federal Tax Consequences of Traditional IRA Withdrawals
Traditional IRA distributions are always subject to federal income tax unless you've made nondeductible contributions. That's because you generally receive a tax deduction for your contributions in the year you make them. If you put money in your traditional IRA and didn't take a deduction for the contribution on your tax return, however, a portion of your withdrawal is tax free. The tax-free portion is calculated by dividing the amount of nondeductible contributions in your IRA by the total value of your IRA. For example, if your traditional IRA holds $5,000 of nondeductible contributions and it's worth $50,000, 10 percent of your distribution is tax free.
Early Withdrawal Penalties
The federal government tacks on a 10-percent penalty if you take money out of your IRA before age 59 1/2 unless an exception applies. You must also pay income tax on the withdrawal. Exceptions include using the money to buy a first home, higher education or high medical costs.
Taxable distributions from IRAs count as ordinary income -- the money is taxed at the same rate as your salary or other earnings. IRA withdrawals never qualify for the lower capital gains rates, even if you invested the money into capital assets like stocks or real estate while the money was held in your IRA.
State Tax Consequences
Most states follow the same rules as the federal government for taxing IRA withdrawals, but some have unique provisions that differ. For example, according to the Wall Street Journal, Illinois, New York, Pennsylvania and New Jersey don't tax at least a portion of your IRA income. But you may have to meet certain age requirements, such as being older than 59 1/2 to get these perks. Some states, such as California, tack on additional penalties for early withdrawals.
- IRS: Publication 590-B
- California FTB: 2014 Instructions for Form FTB 3805P
- IRS.gov. "Income ranges for determining IRA eligibility change for 2021." Accessed Oct. 30, 2020.
- Internal Revenue Service. "Publication 590-B (2018), Distributions from Individual Retirement Arrangements (IRAs)." Accessed Sept. 30, 2019.
- U.S. Congress. "H.R.1994 - Setting Every Community Up for Retirement Enhancement Act of 2019." Section 113.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."