Tax-deferred individual retirement accounts (IRAs) offer a valuable tax deduction for contribution and tax-sheltered growth. But the Internal Revenue Service counts the distributions as taxable income. Learning the rules for taxable IRA distributions can help you plan your distributions to minimize your taxes, while also avoiding penalties.
When you take a distribution from a tax-deferred IRA, the entire amount of the distribution is taxable. However, if you made contributions to the IRA that you did not deduct, a portion of the distribution comes out without being taxed. The nontaxable portion of the distribution equals the percentage of your IRA comprised of nondeductible contributions. For example, if you put $13,000 of nondeductible contributions in your traditional IRA, and at the time of your distribution the account was worth $104,000, divide $13,000 by $104,000 to find that 0.125, of 12.5 percent, of your distribution is tax free.
When you take a distribution from your taxable IRA before age 59 1/2, you must pay a 10 percent nonqualified withdrawal penalty. This penalty only applies to the taxable portion, but you can avoid it in certain exceptional circumstances. For example, you can take a penalty free distribution before age 59 1/2 to pay for college tuition for yourself or a dependent, or for medical costs exceeding 7.5 percent of your adjusted gross income (AGI).
The IRS does not treat a taxable IRA withdrawal differently than other taxable income on your tax return. When you add the taxable amount to your other income, it gets taxed at your marginal tax rate. For example, if you take an $8,000 distribution and fall in the 27 percent tax bracket, and your IRA distribution does not move you into a higher bracket, you would pay $2,160 in taxes on the distribution. If it does put you in a higher bracket, you are taxed on the portion in the higher bracket at the higher rate. Using the same example, if $2,000 fell in the higher tax bracket, that $2,000 would be taxed at the higher rate, but the first $6,000 would be taxed at the lower rate.
The IRS requires you to begin taking withdrawals from your IRA in the year you turn 70 1/2. These withdrawals are taxable, unless you have a Roth IRA. With a Roth IRA, the taxes are made on the contributions, so the withdrawals are tax free. If you do not remove enough at age 70 1/2, the unwithdrawn portion is hit with a 50 percent tax penalty. For example, if you were supposed to take out $5,000 but you only took out $4,000, you would owe a $500 penalty on the $1,000 you did not take out.
- Comstock/Comstock/Getty Images