IRAs: How Are They Taxed and When?

How IRAs are taxed depends on whether the IRA is a traditional or a Roth IRA. Traditional IRAs involve making tax-free contributions, meaning you contribute to your IRA before taxes are taken out. This may reduce your taxable income for the year in which you’ve contributed to your IRA, therefore reducing the amount of tax you pay that year. When you start withdrawing from your account at retirement age, you will pay taxes on the funds you take out. With a Roth IRA, you contribute to your IRA after you’ve paid taxes for the year; and when you make withdrawals at retirement age, you don’t pay any taxes on the funds you take out.

Which Is Better: Roth or Traditional?

It depends on your financial needs and circumstances. Of course, no one can predict what will happen in the future, but if you expect to be in a lower tax bracket when you reach retirement age, financial professionals generally recommend a traditional IRA option. This allows you to lower your income taxes as you contribute to your IRA, then withdraw money at retirement at a presumably lower tax rate.

If, however, you expect to be in a higher income tax bracket in your retirement years, a Roth IRA may be to your advantage. This allows you to take care of the taxes now and enjoy tax-free withdrawals later in life, without having to pay more taxes because you’re in a higher tax bracket.

Will My Taxes Be Higher Now or After Retirement?

Again, this depends on your current income versus your income level at retirement and prevailing tax brackets. If your projected income level at retirement is higher than current income, you’ll likely have higher income taxes at that time.

This could also dictate your financial decisions now and help inform whether a traditional IRA or Roth IRA is right for you.

Can Money Be Withdrawn Early?

Early withdrawals from traditional or Roth IRAs generally have associated taxes and penalties unless you have a qualifying exception under IRS rules.

You can always withdraw contributions from your Roth IRA without penalty or taxes at any age. However, you will be taxed on the earnings from your Roth if you haven’t reach age 59½ or had the account for less than five years. Find out more about IRA withdrawals.

What is the Roth IRA Five-Year Rule?

To withdraw from a Roth IRA without penalty, you must be age 59½ and have held the account for a minimum of five years. This is often called the “Five-Year Rule.” The clock for five years starts on January 1 of the year in which you made your first contribution. If you withdraw from the account before the five-year mark, you will pay a 10% penalty and income taxes on earnings withdrawals.

Tax Penalties for Early Withdrawals

You can easily calculate penalties for early withdrawals on IRAs. Just multiply the taxable distribution amount by 10%. Also keep in mind the distribution will be treated as additional income. You’ll be taxed on that amount in the year you take out the distribution. This applies to traditional IRAs as well as to Roth IRA earnings; that is, when you withdraw from your Roth IRA account anything above what you’ve put into it, before you’re eligible to withdraw from it.

Distributions to Charities

Qualified Charitable Distributions or QCDs are a strategic approach to philanthropy while lowering your taxes on traditional IRA distributions. QCDs apply only to traditional IRAs, which have taxes associated with withdrawals, so QCDs don’t apply to distributions from a Roth IRA.

You qualify to make QCDs starting at age 70½ or older. You may make up to $100,000 in charitable contributions per year to a qualified 501(c)3 organization from your IRA. Any QCD you make is tax-free and qualifies as a “distribution” toward your Required Minimum Distribution or RMD for the year.

Need More Information on IRAs?

Contact MissionSquare Retirement.