Popular Stories

How Are IRA Withdrawals Taxed?

The way individual retirement account (IRA) withdrawals are taxed depends on the type of IRA. You’ll pay tax on withdrawals from a traditional IRA, but with a Roth IRA, there is no tax due at withdrawal on either contributions or earnings, provided you meet certain requirements.

Early withdrawals (which happen before age 59½) from any type of qualified retirement account, such as IRAs and 401(k) plans, come with a 10% penalty, as well as any income taxes due, though there are some exceptions to this rule.

Both traditional and Roth IRAs are subject to the same annual contribution limits. The limit is $6,000 for 2021 and 2022. If you are 50 or older, you can contribute an additional $1,000, which is known as a catch-up contribution.

Key Takeaways

  • Contributions to traditional IRAs are tax-deductible, earnings grow tax-free, and withdrawals are subject to income tax.
  • Roth IRA contributions are not deductible.
  • Roth IRA withdrawals are tax-free if the owner had the account for at least five years.
  • Because contributions to Roth IRAs are made with after-tax money, they can be withdrawn at any time, for any reason.
  • Early withdrawals (before age 59½) from a traditional IRA—and withdrawals of earnings from a Roth IRA—are subject to a 10% penalty, plus taxes, though there are exceptions to this rule.

How Traditional IRA Withdrawals Are Taxed

With a traditional IRA, any pre-tax contributions and all earnings are taxed at the time of withdrawal. The withdrawals are taxed as regular income (not capital gains), and the tax rate is based on your income in the year of the withdrawal.

The idea is that you are subject to a higher marginal income tax rate while you are working and earning more money than when you have stopped working and are living off of retirement income—although this is not always the case.

Although taxes are assessed at the time of withdrawal, there are no additional penalties, provided that the funds are used for a qualified purpose or that the account holder is 59½ years of age or older. Qualified purposes for an early withdrawal from a traditional IRA include a first-time home purchase, qualified higher education expenses, qualified major medical expenses, certain long-term unemployment expenses, or if you have a permanent disability.

Traditional IRA contributions can be tax-deductible or partially tax-deductible based on your modified adjusted gross income (MAGI) if you contribute to an employer-sponsored plan, such as a 401(k).

In 2021, an individual with a MAGI between $66,000 to $76,000 is eligible for at least partial deductibility, as is a married couple filing jointly with a MAGI of between $105,000 to $125,000. For 2022, the MAGI for individuals is $68,000 to $78,000, and for married couples filing jointly, it’s $109,000 to $129,000. There are no income limits on who can contribute to a traditional IRA.

How Roth IRA Contributions Are Taxed (or Not)

Because Roth IRA contributions are made with after-tax dollars, you can withdraw them tax-free for any reason at any time. But this also means they are not tax-deductible as contributions to a traditional IRA can be. And keep in mind that you can only contribute earned income to a Roth IRA.

You can withdraw earnings without penalties or taxes as long as you’re 59½ or older and you have had a Roth IRA account for at least five years. Although it can be hard to predict, if you think you will be in a high tax bracket when you retire, a Roth IRA may be a good choice.

Like a traditional IRA, you can avoid the 10% penalty for withdrawals if the money is used for a first-time home purchase, qualified education expenses, medical expenses, or if you have a permanent disability. You’ll still pay taxes on the amount withdrawn, though.

Not everyone is eligible to contribute to a Roth IRA. Unlike a traditional IRA, there are income limits. In 2021, only individuals with a MAGI of $140,000 ($144,000 for 2022) or less are eligible to participate in a Roth IRA. The phase-out for singles starts at $125,000 ($129,000 for 2022). For those married filing jointly, the 2021 MAGI limit is $208,000 ($214,000 for 2022), with a phase-out starting at $198,000 ($204,000 for 2022). If you earn too much to contribute to a Roth directly, you might be able to make contributions indirectly via a strategy known as a backdoor Roth IRA.

View Article Origin Here

Related Articles

Back to top button