The way individual retirement account (IRA) withdrawals are taxed depends on the type of IRA. You’ll pay tax on traditional IRA withdrawals. But with a Roth IRA, there is no tax due when you withdraw contributions or earnings, provided you meet certain requirements.
Early withdrawals–those that happen before age 59 1/2 –from any qualified retirement account, including IRAs and 401(k) plans, come with a 10% penalty. Early withdrawals also trigger income taxes on the distributed amounts, though there are some exceptions to this rule.
How Traditional IRA Withdrawals Are Taxed
With a traditional IRA, withdrawals are taxed as regular income (not capital gains), based on your tax bracket the year of the withdrawal. There are currently seven federal tax brackets in the U.S., ranging from 10% to 37%.
Both traditional and Roth IRAs are subject to the same annual contribution limits. The limit is $6,000 for 2021 and 2022. If you are 50 or older, you can contribute an additional $1,000 catch-up contribution.
The idea is that you are subject to a higher marginal income tax rate while you are working and earning more money than when you have stopped working and are living off of retirement income. Of course, this is not always the case.
Qualified traditional IRA withdrawals
Although withdrawals are taxed the year you make them, there are no additional penalties if you’re at least 59 1/2 or you use the funds for a qualified purpose.
Qualified purposes for an early withdrawal from a traditional IRA include a first-time home purchase, qualified higher education expenses, qualified major medical expenses, certain long-term unemployment expenses, or if you have a permanent disability.
Deducting traditional IRA contributions
For the 2021 tax year, an individual with a MAGI between $66,000 to $76,000 is eligible for at least partial deductibility, as are married couples filing jointly with MAGIs between $105,000 to $125,000.
For 2022, the MAGI for individuals is $68,000 to $78,000. It’s $109,000 to $129,000 for married couples filing jointly. Unlike Roth IRAs, there are no income limits on who can contribute to a traditional IRA.
Traditional IRA holders (and 401(k) plan participants, too) who are 72 years and older must take required minimum distributions (RMDs), which are subject to taxes. RMDs used to start at 70 1/2 , but the age was lifted under the Setting Every Community Up for Retirement Enhancement (SECURE) Act.
How Roth IRA Contributions Are Taxed
Because you make Roth IRA contributions with after-tax dollars, you can withdraw them tax-free at any time with no tax or penalty. But this also means contributions are not tax deductible like those made to traditional IRAs are. And keep in mind that you can only contribute earned income to a Roth IRA.
Earned income is money you receive for working, such as wages, salaries, bonuses, commissions, tips, and net earnings from self-employment. Conversely, income derived from investments and government benefit programs is considered unearned income.
Qualified Roth IRA withdrawals
You can withdraw earnings without penalties or taxes as long as you’re 59 1/2 or older and have had a Roth IRA account for at least five years. Although it can be hard to predict, a Roth IRA may be a good choice if you think you will be in a higher tax bracket when you retire.
Like a traditional IRA, you can avoid the 10% penalty for early withdrawals if you use the money for a first-time home purchase, qualified education expenses, medical expenses, or if you have a permanent disability. You might still pay taxes on the amount withdrawn, depending on how long it’s been since you first contributed to a Roth.
Roth IRA income limits
Not everyone is eligible to contribute to a Roth IRA. Unlike a traditional IRA, there are income limits. For 2021, only individuals with a MAGI of $140,000 ($144,000 for 2022) or less are eligible to participate in a Roth IRA. The phase-out for singles starts at $125,000 ($129,000 for 2022).
For those married filing jointly, the 2021 MAGI limit is $208,000 ($214,000 for 2022), with a phase-out starting at $198,000 ($204,000 for 2022). If you earn too much to contribute to a Roth directly, you might be able to make contributions indirectly via a strategy known as a backdoor Roth IRA.
How Much Tax Do You Pay on IRA Withdrawals?
That depends on several factors, including the type of IRA, your age, and how long it’s been since you first contributed to an IRA.
If you have a Roth IRA, you can withdraw your contributions at any time with no tax or penalty. To withdraw your earnings, you have to wait until you’re 59 1/2 or older and it’s been at least five years since you first contributed to a Roth IRA to avoid taxes and penalties.
Withdrawals from traditional IRAs are subject to income taxes at your ordinary tax rate, and early withdrawals may be subject to a 10% penalty tax. There are exceptions to the rules that allow early withdrawals without triggering the penalty and taxes.
When Do RMDs Start?
RMDs only apply to traditional IRAs; there are no RMDs for Roth IRAs during the account owner’s lifetime.
The Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act) made significant changes to the RMD rules. If you reached age 70 1/2 in 2019, the prior rule applies, and you had to take your first RMD by April 1, 2020. If you reach age 70 1/2 in 2020 or later, you must take your first RMD by April 1 of the year after you turn 72.
How Are RMDs Calculated?
RMDs are generally calculated by dividing the account’s prior Dec. 31 balance by the appropriate life expectancy factor the IRS publishes in Publication 590-B, Distributions from individual retirement arrangements (IRAs). You must calculate the RMD separately for each IRA you own, but you can withdraw the total amount from one or more IRAs.
The Bottom Line
The withdrawal rules for IRAs depend on the type of IRA, your age, and how long it’s been since you first contributed to an IRA. In general, Roth IRAs offer more flexibility because you can withdraw your contributions at any time, qualified withdrawals are tax-free, and they aren’t subject to RMDs during the account owner’s lifetime.
On the other hand, traditional IRA withdrawals are taxed at your ordinary income tax rate, and you must start taking RMDs the year you turn 72. The penalty for not taking RMDs is steep: Whether you fail to take the RMD by the deadline or don’t withdraw enough, the amount not withdrawn is taxed at 50%.