Traditional IRAs
The money that your employer sends to the IRA is not subject to federal income taxes. This allows your retirement savings to grow tax-free. However, when you begin to withdraw these funds, they are considered taxable income.
I.e. Wages = tax free | IRA withdrawals = taxable
Penalties on Withdrawals
Once you reach 59 1/2 you can start benefiting from the savings in your retirement plan. You may start to draw out the funds for whatever purpose, but the IRS gets its share come April 15 and you need to know the right amount to be paid as you withdraw from your Personal Retirement Account.
IRS is well within its rights by requiring the levied tax payments, but that doesn’t make it any less annoying nor does it mean that you have to pay more tax than you need to. Your tax advisor can help relieve you from at least a little bit of the reluctance if not from the total penalty in case you decide to withdraw some of the funds.
Some of the retirement plans impose penalty on any early withdrawals from the plan and the majority of retirement plans used do. However if you are not penalized in any way, then you might as well withdraw from your IRA.
You can get a clear idea of what to expect from your tax advisor, but in most cases you will be required to pay some forced hardship after you are at the age of 50 and have held the account for a minimum of five years.
IRA Account Rollovers
So you’ve done it. You’ve reached age 70 1/2 and have to take the required minimum distribution from your IRA account. Does this mean you have to pay income tax?
It depends on how you receive your distribution. Not surprisingly, there are a few wrinkles in this one.
If you receive a lump sum distribution from your traditional IRA, you will have to pay income tax on the entire amount. This is because you choose to pay taxes when you make the contribution to your traditional IRA, and this distribution is considered a taxable event.
If you roll over your IRA funds into a new traditional IRA, this is considered a tax-free rollover. This is because you are not receiving cash, just a transfer of funds from one retirement account to another tax-deferred account. So this is entirely tax-free.
But you likely will have a minimum distribution requirement in this account until you reach age 70 1/2. With this type of transfer, the taxman will also let you choose the method of taxation. This is to prevent you from stuffing the money into a Roth IRA account to delay your taxes.
Roth IRAs
Before you can determine whether an IRA distribution will be taxable, you'll need to identify whether or not you have a Roth IRA or a Traditional IRA. Both have tax advantages, but they are also taxed differently.
A Roth IRA (Individual Retirement Account) is funded with tax-deductible contributions. They are taxed as money comes out. A Traditional IRA is funded with money that is taken out of your paycheck on a before-tax basis. When money comes out of a traditional IRA it is taxed as income.
These are two important differences. If the IRA is a Roth IRA, it is taxed as it comes out. If it is a Traditional IRA, the taxes are deferred until a distribution occurs.
Your treatment of the IRA that is in a Roth IRA will depend largely on the tax bracket you want to be in. If you want to save the money to take advantage of a lower tax bracket, then you will want to use a Roth IRA. You have to be aware that the money that you will be putting in is taxed, as the money comes out. But the future growth and the distributions will be tax free.
Summary
Things Not to do with your IRA distribution
No, not all IRA distributions are taxable. You knew there had to be a catch somewhere, didn’t you? When you withdraw money from your IRA, it’s called a distribution. Not all distributions are the same, and not all distributions are taxable. Here’s a breakdown of the various types of distributions.
Normal Distributions
To determine if your withdrawal is a normal distribution (i.e., not taxable), you need to determine whether you are under age 59 1/2. If you are, then you must determine whether the money you’re withdrawing is attributable to your after-tax contributions or to your pretax contributions. If none of the distribution is attributable to your after-tax contributions, then none of the withdrawal is taxable. If any of the distribution is attributable to your after-tax contributions, then a portion of the distribution is taxable.