Calculating Taxes On IRA Distributions - Step By Step
IRAs offer the opportunity to save for retirement on a tax-deferred or tax-free basis (in the case of a Roth IRA). While your money grows free from taxes while invested inside of the IRA account, there may be taxes, and in some cases a 10% penalty, to be paid when the money is withdrawn.
Taxes on any IRA distribution that is taxable are ordinary income taxes and are added on top of other income that you might have from employment or other sources. Even though the investments inside of the IRA may have recorded gains, there are no preferential tax rates for these capital gains as there are for capital gains in a taxable investment account.
Let’s look at how to calculate the taxable amount on an IRA distribution.
Traditional IRA Distributions
Contributions to a Traditional IRA can be made on a pre-tax basis in many cases. The exception to this occurs if you are covered by a workplace retirement plan like a 401(k) and your income exceeds a certain level. Contributions can also be made on an after-tax basis with no tax benefit upfront.
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, the IRS won’t do this.
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 under the age of 59 ½, distributions may be subject to a 10% penalty 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 7.5% 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.
- Made as a series of substantially equal payments.
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.
Roth IRA Distributions
One of the main attractions of a Roth IRA is that account distributions will not be taxed in retirement if certain conditions are met. Contributions to a Roth IRA are made on an after-tax basis, however the account is then free to grow on a tax-free basis.
Qualified distributions will not be subject to income taxes. These include:
- 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 by those under 59 ½ who have satisfied the five-year requirement will not be subject to ordinary income tax if they are:
- In connection with a disability.
- Distribution is used to buy or build a first home (up to $10,000).
- Used for qualified expenses related to the birth or adoption of a child.
- Related to your disability or death.
- Being used 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 to 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 to 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 7.5% of your adjusted gross income for the year.
- Health insurance premiums while you're unemployed.
- Due to a 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.
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.
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 less 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.
Before you consider an IRA distribution, you should be aware of all potential taxes and penalties.