How To Calculate Taxable Amount Of An IRA Distribution

Some of the most well-known investment vehicles, known as IRAs, offer an opportunity to save for retirement in a tax-advantaged way. Whether it is tax-deferred or tax-free, these vehicles can help you secure a wealthy retirement.

While both a Traditional and Roth IRA offer great tax advantages for those focused on growth, users need to be aware of taxes and early withdrawal penalties that exist.  

The tax rate on any taxable IRA distribution is your ordinary income tax rate. Even though the investments inside of your IRA may have recorded gains, there are no preferential tax rates for these capital gains. This is different from capital gains that are earned in taxable investment accounts. 

Understanding how your retirement accounts will be taxed is an important piece in your goal for financial independence. Let’s look at how to calculate the taxable amount on an IRA distribution.

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Traditional IRA Distributions

Contributions to a Traditional IRA can be made on a pre-tax basis. This is true in most cases. However, if your income exceeds a certain level, you will not be able to benefit from contributions to your Traditional IRA.

For the year 2022, the full deductibility amounts have changed from years past. Users will have full deductibility benefits if their MAGI is $105,000 or less (joint) and $66,000 or less (single); partial deductibility benefits are available up to $125,000 (joint) and $76,000 (single).

If you do not fall within the numbers listed above, you can still contribute to a Traditional IRA and receive benefits from growth, but you will not have the same tax benefits of deducting your contributions.  

Withdrawals from a Traditional IRA account are always subject to ordinary income taxes except for any amount contributed on an after-tax basis. It is the job of the account holder to keep track of after-tax contributions for this purpose. 

Earnings on the funds invested within the account, whether the contributions were made on a pre-tax or an after-tax basis, are always taxable when distributed from the account. 

If you are hoping to withdraw funds before you reach the age of 59 ½, distributions may be subject to a 10% penalty. This is in addition to any taxes due. There are some exceptions to this 10% penalty outlined below.

Exceptions to the 10% Penalty

• To cover the costs of unreimbursed medical expenses that exceed 10% of your adjusted gross income. The expenses must be paid in the same calendar year the withdrawal is made.
• To pay health insurance premiums while you are unemployed.
• Distributions made if you become permanently disabled.
• To cover qualified higher education expenses for you, your spouse, or your dependents.
• Distributions from an IRA that you inherit.
• To cover a tax levy from the IRS.
• Made by an armed forces reservist on active duty. In some cases, these distributions can be paid back to the account.
• First-time homebuyers, up to $10,000

Most of these exceptions have specific rules and conditions attached to them, you should consider consulting a tax professional if one or more of these situations apply to you. 

To see the full list, visit the IRS website.

Roth IRA Distributions

Roth IRAs gain most of their popularity because they are not taxed upon distribution if certain conditions are met. Contributions to a Roth IRA are made on an after-tax basis, which means you are unable to deduct your distributions from your income. There is an exception to this which you can view here.

While this may be damaging in the short term, investors are then able to grow their money on a tax-free basis. 

Qualified distributions will not be subject to income taxes if the following conditions are met: 

• Distributions in the amount of your original contributions to your Roth account only.
• Distributions made on or after you reach age 59 ½. Your first contribution to a Roth IRA account must have been at least five years ago (the five-year rule).

In addition, distributions made to those under 59 ½ who have satisfied the five-year requirement will not be subject to ordinary income tax if funds are used:

• In connection with a disability.
• To buy or build a first home (up to $10,000).
• For qualified higher education expenses.
• Related to your disability or death.
• For unreimbursed medical expenses or the cost of health insurance if you are unemployed.
• As part of a series of substantially equal payments (this must last at least five years or until you reach age 59 ½).

Taxes and Penalties

Distributions from a Roth IRA may be subject to income taxes and in some cases the 10% penalty. Here are a few common scenarios to consider:

• If you are at least age 59 ½ but have not met the five-year requirement, distributions of earnings from the account will be taxed, but not subject to the 10% penalty. Withdrawals of your contributions are never taxed.
• If you are under age 59 ½ and have met the five-year rule, the earnings portion of the distribution will be subject to both taxes and the 10% penalty. The penalty may be waived if your situation meets one of the exceptions listed below. Taxes and penalties may both be waived for the situations listed above.
• If you are under age 59 ½ and have not met the five-year rule, the earnings portion of the distribution will be subject to both taxes and the 10% penalty. The penalty may be waived if your situation meets one of the exceptions listed below. 

Exceptions to the 10% Early Withdrawal Penalty Include: 

• Qualified higher education expenses for your or family members.
• Unreimbursed medical expenses that exceed 10% of your adjusted gross income for the year.
• Health insurance premiums while you're unemployed.
• Due to death or disability.
• Childbirth or adoption expenses within a year after the birth or adoption up to $5,000.
• A series of substantially equal payments from the account. This must continue for at least five years or until you reach age 59 ½.
• Distributions to satisfy an IRS levy.
• Distributions made by an armed forces reservist on active duty. 

Roth Conversions 

Converting a Traditional IRA to a Roth IRA can be a solid financial move in some cases, depending upon your situation.

While this is not a distribution in the sense of receiving cash from the IRA account, by doing a Roth conversion you are taking the funds from the Traditional IRA account and converting those funds to a Roth IRA account. These funds will then not be taxed when withdrawn in retirement assuming the appropriate conditions are met. 

Funds converted to a Roth IRA from a Traditional IRA will be subject to income taxes, with the exception of money contributed on an after-tax basis. Where there is after-tax money involved, the money converted will be taxed on a prorated basis of the after-tax portion as a percentage of all Traditional IRA funds across all Traditional IRA accounts held. 

It is also important to note the 60 day requirement when conducting a rollover. If the distribution is paid directly to you, then  you have 60 days to contribute the funds to the new IRA or retirement plan. Failure to do so will result in a tax liability. Additionally,

How to Convert/Rollover a Retirement Account

Your financial advisor can assist you with rolling over an old 401(k) from a previous employer or a Traditional IRA. They can also assist with a Traditional IRA to Roth IRA conversion. You can also work with a robo-advisor who can accomplish this for you, often with fewer fees.

Betterment is a low fee robo-advisor that has an asset management fee of 0.25% to 0.40% annually. They also have a team dedicated to Roth conversions and account rollovers. They handle the entire process online with relative ease.

M1 Finance offers something called rollover concierge service. They guide you through the process step by step and do all the leg work for you. This brokerage offers 100% fee-free Roth IRAs which allow you to keep more of your money invested, rather than paying high fees.

State Income Taxes With IRA Distributions

The discussion above only covered federal income taxes. Most states also tax IRA distributions from Traditional accounts in some fashion, but not all do. It’s best to check on the rules for your state prior to taking a distribution. 

If you have questions about IRA distributions, it may be helpful to discuss your plans with a CPA or certified financial planner.

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