Federal Tax Rules on IRA Withdrawals

By Shani Valdez

  • Overview

    Federal Tax Rules on IRA Withdrawals
    There are various tax-deferred and nondeductible IRA accounts a taxpayer may elect to use as his retirement vehicle. However, there are also various tax implications when withdrawing funds from these accounts. These tax implications can affect you significantly and need to be kept in mind when choosing a retirement vehicle or making distributions from an account.
  • The facts

    Roth IRAs offer the most flexibility when it comes to withdrawals out of IRAs. The only time there need be concern about federal taxes for a Roth would be for: non-qualified distributions; early withdrawal exceptions; or earnings and tax-deductible conversion withdrawals before the mandatory five-year holding period (for account establishment and individual conversion holding periods). Most taxpayers will benefit tax-wise if qualified to make contributions and conversions, but discuss the tax implications with your tax adviser first. Non-Roth IRAs follow guideline similar to traditional IRAs in regards to distributions.
  • Traditional IRAs

    Unless your modified AGI (MAGI) limits are beyond the income threshold for tax-deductible contributions, all contributions made are tax-deductible. If you believe your federal taxes will be significantly lower at retirement, then this may be a good retirement vehicle. Nondeductible contributions will not be taxed again when withdrawing funds, but any attributable earnings will be taxed; it is extremely important to file nondeductible contributions on form 8606 and keep it safely filed so that you have it when needed by the IRS to determine your taxes when taking distributions. Financial institutions will not ask you what type of contribution you are making. Therefore, it is up to you to keep track of this information if you have a mixture of tax-deductible and nondeductible contributions when filing your tax return or withdrawing funds from your IRA.

  • Roth IRAs

    There are times when making Roth IRA distributions that you will be required to pay taxes at your marginal interest rate. Contributions can be withdrawn anytime without further taxation, but conversions and capital earnings require careful consideration to avoid further taxation. Presuming you met your five-year holding period, conversions come out tax-free; if your conversion has not met its holding requirements, you won't be penalized, but you will be taxed for an early withdrawal. In order to withdraw earnings tax-free, your account must meet its five-year holding period, and you must be eligible for a qualified distribution; if you meet one of the early exceptions, you won't be penalized for your early withdrawal, but you will be assessed taxes on your distribution. Earnings taken out not fulfilling any of these exceptions will not only be taxed, but penalized as well.
  • SEP IRAs

    SEP IRAs are tax deferred IRA accounts that work much the same as traditional IRAs in regards to withdrawals of contributions and capital gains. If you are age 59½, you meet the age requirements to take out distributions without penalty. Your distributions will be taxed, like a traditional IRA, at your current federal tax rate. Like traditional IRAs in regards to Required Minimum Distributions (RMDs), you must start taking distributions no later than age 70½; otherwise you will face tax penalties on the required distributions by the IRS.

    SIMPLE IRAs work similarly to traditional IRAs as well in regards to the minimum age at which funds can be withdrawn free of penalties (59½) and when RMDs are required (70½). However, there is one catch in withdrawing funds. You will be assessed a 25 percent tax penalty if you withdraw funds from your SIMPLE IRA within the first two years of your first contribution. So make it a point not to withdraw funds until after the two-year mark of your first contribution.
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