The way individual retirement account (IRA) withdrawals are taxed depends on the type of IRA. You pay taxes on traditional IRA withdrawals. But with a Roth IRA, no taxes are due when you withdraw contributions or income, provided you meet certain requirements.
Early withdrawals — those that occur before age 59½ — from any qualifying retirement account, including IRAs and 401(k) plans, come with a 10% penalty. Early withdrawals also result in income taxes on the amounts distributed, although there are some exceptions to this rule.
Key learning points
- Contributions to traditional IRAs are tax-deductible, income grows tax-free, and withdrawals are subject to income tax.
- Roth IRA contributions are not tax-deductible, earnings grow tax-free, and qualified withdrawals are tax-free.
- Because contributions to Roth IRAs are made with after-tax money, you can withdraw them at any time, for any reason, with no tax or penalty.
- Early withdrawals (before age 59½) from a traditional IRA or Roth IRA are generally subject to a 10% penalty plus taxes, although there are 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 in the year of withdrawal. As of 2022, there are seven federal tax brackets in the US ranging from 10% to 37%.
Both traditional and Roth IRAs are subject to the same annual contribution limits. The limit is $6,000 for 2022 and $6,500 for 2023. If you are 50 or older, you can contribute an additional $1,000 catch-up ($6,500 in 2022 and $7,500 in 2023).
The idea is that you pay a higher marginal income tax rate while you work and earn more than if you stop working and live on retirement income. Of course this is not always the case.
Qualified Traditional IRA Withdrawals
While withdrawals are taxed in the year you make them, there are no additional penalties if you are at least 59½ or if you use the money for a qualified purpose.
Qualifying purposes for an early withdrawal from a traditional IRA include a first home purchase, qualified higher education expenses, qualified major medical expenses, certain long-term unemployment expenses, or if you have a permanent disability.
Subtract from traditional IRA contributions
Traditional IRA contributions may be tax-deductible or partially tax-deductible based on your adjusted adjusted gross income (MAGI) if you contribute to an employer-sponsored plan, such as a 401(k).
For the 2022 tax year, an individual with a MAGI between $68,000 and $78,000 is eligible for at least partial deductibility, as do married couples filing jointly with MAGIs between $109,000 and $129,000.
For 2023, the phase-out range will be increased to between $73,000 and $83,000 (up from between $68,000 and $78,000 in 2022), and for married couples filing jointly, the phase-out range will be increased to between $116,000 and $136,000 (instead of between $109,000 and $129,000 in 2022). Unlike Roth IRAs, there are no income limits on who can contribute to a traditional IRA.
How Roth IRA Contributions Are Taxed
Because you’re making 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 that contributions are not tax-deductible like those to traditional IRAs. 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 self-employment income. Conversely, income from government investments and benefit programs is considered unearned income.
Qualified Roth IRA Withdrawals
You can withdraw income without penalties or taxes as long as you are 59½ years old or older and have had a Roth IRA account for at least five years. While it can be difficult to predict, a Roth IRA can be a good choice if you think you’ll fall into a higher tax bracket in retirement.
Like a traditional IRA, you can avoid the 10% early withdrawal penalty if you use the money for a first home purchase, qualified education expenses, medical expenses, or if you have a permanent disability. You may still pay taxes on the amount withdrawn, depending on how long it has 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 2022, only individuals with a MAGI of $144,000 ($153,000 for 2023) or less are eligible to participate in a Roth IRA. The singles phase-out starts at $129,000 in 2022 ($138,000 for 2023).
For those applying together, the 2022 MAGI limit is $214,000 ($228,000 for 2023), with a phase-out starting at $204,000 ($218,000 for 2022). If you earn too much to contribute directly to a Roth, you may be able to contribute indirectly through 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 without tax or penalty. To withdraw your earnings, you must wait until you are 59½ years or older and it has 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 tax at your ordinary tax rate, and early withdrawals may be subject to a 10% penalty. 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 life of the account owner.
The Seting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act) made significant changes to the RMD rules. If you reached age 70½ in 2019, the preceding rule applies and you must take your first RMD before April 1, 2020. If you reach age 70½ in 2020 or later, you must take your first RMD before April 1 of the year after you turn 72.
How are RMDs calculated?
RMDs are generally calculated by dividing the account balance prior to December 31 by the applicable life expectancy factor that the IRS publishes in Publication 590-B, Distributions from Individual Retirement Plans (IRAs). You must calculate the RMD separately for each IRA you own, but you can include the total amount of one or more IRAs.
It comes down to
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 are not subject to RMDs during the life of the account owner.
On the other hand, traditional IRA withdrawals are taxed at your regular income tax rate, and you must start taking RMDs the year you turn 72. The penalty for not withdrawing RMDs is high: whether you don’t take the RMD on time or don’t withdraw enough, the non-withdrawn amount will be taxed at 50%.