Taxation Rules for IRA Distributions

by Matt Kuchera

Individual retirement accounts (IRAs) offer a tax-advantaged way to save for retirement. Traditional IRAs allow you to defer paying taxes on the money you invest until you need it in retirement, while Roth IRAs allow your earnings to grow tax free if you pay taxes up front on the money you invest. To get the most advantage out of these accounts, you need to make sure you are aware of the rules for distributions.

Traditional IRAs

Traditional IRAs include individual IRAs and certain types of employer-sponsored IRAs, such as Savings Incentive Match Plan for Employees (SIMPLE) IRAs and Simplified Employee Pension (SEP) IRAs. The distribution rules are the same for all of these IRAs. Once you turn 59 1/2, you can start withdrawing money from these IRAs without penalty. You will pay income tax on any money you withdraw at your current income tax rate. This is because the money in the account is earned income on which you have not yet paid taxes.

Roth IRAs

Roth IRA withdrawals are generally tax free as long as you meet the qualifications for withdrawals. Because you fund Roth accounts with after-tax dollars, you can withdraw your contributions at any time tax free. To withdraw earnings tax-free, you must be at least 59 1/2 and also have owned the Roth IRA for at least five years.

Early Withdrawals

The Internal Revenue Service gives favorable tax treatment to IRAs because they encourage saving for retirement. For this reason, the IRS discourages withdrawing the money prior to retirement and levies substantial penalties in many cases for doing so. If you take any money out of a traditional, SIMPLE or SEP IRA that is not for a qualifying purpose such as a first-time home purchase or to pay for education expenses, you will have to pay a 10 percent penalty tax in addition to regular income taxes. In addition, if you take an early distribution from a SIMPLE IRA within two years of beginning participation in the plan, you face a 25 percent penalty. If you have a Roth IRA, you will pay a 10 percent penalty and income taxes on any non-qualifying amounts you withdraw early that exceed your contributions.

Other Penalties

Early withdrawal penalties aren't the only tax penalties that apply to IRAs. If you have a traditional, SIMPLE or SEP IRA, you are required to start taking minimum distributions from the account in the year in which you turn 70 1/2. If you do not, the IRS levies a 50 percent excise tax on the amount you should have withdrawn but didn't. This rule does not apply to Roth IRAs. The IRS also levies a tax of 6 percent on any excess contributions to traditional, SIMPLE, SEP or Roth IRAs. You can contribute $5,000 annually to a traditional IRA if you are under age 50, and $6,000 if you are 50 or older. If you contribute more than these amounts, the excess contribution itself, plus any earnings on it, will be taxed at 6 percent. The 6 percent excise tax also applies to SIMPLE and SEP IRA contributions; however, because they are employer-sponsored programs, they have much higher contribution limits. Limits on SIMPLE IRAs are currently $11,500 annually if you are under 50, and $14,000 if you are 50 or older. The contribution limits for SEP IRAs are $49,000 annually or 25 percent of salary, whichever is lower. There are no SEP IRA catch-up provisions for people 50 and older.

About the Author

Matt Kuchera has been a professional journalist for nearly 20 years. His career has included stints as a copy editor, page designer, reporter, line editor and managing editor at newspapers ranging from community newspapers to major metros. Kuchera has been a business writer and editor for a decade.