How Are Distributions From an IRA Taxed?

An Individual Retirement Arrangement (IRA) is a savings tool that provides tax advantages for retirement savings. A distribution is the process of withdrawing funds from these accounts. The tax treatment can vary significantly based on the type of IRA, your age, and the nature of your contributions.

Taxation of IRA Distributions

The taxability of a distribution from a traditional IRA depends on whether the contributions were made with pre-tax or after-tax dollars. For most individuals, contributions to a traditional IRA are deductible, meaning they are made with pre-tax funds. When you withdraw money from such an account, the entire distribution amount is included in your gross income and taxed at your ordinary income tax rate. This includes both the original contributions and any earnings.

A different set of rules applies if your traditional IRA contains non-deductible, or after-tax, contributions. In this scenario, you have already paid income tax on the money you put in, so you will not be taxed on it again. The IRS applies the pro-rata rule, which dictates that each distribution is a proportional mix of your pre-tax and after-tax funds. To calculate the non-taxable portion of a distribution, you must determine the ratio of your total non-deductible contributions to the total value of all your traditional IRAs. For example, if you have $10,000 in non-deductible contributions and your total IRA value is $100,000, then 10% of any distribution is tax-free, while the remaining 90% is taxable.

Distributions from a Roth IRA operate under a different framework, as contributions are always made with after-tax dollars. A “qualified distribution” from a Roth IRA is completely tax-free. To be considered qualified, a distribution must meet two primary conditions: it must be made after you have held a Roth IRA for at least five years, and it must be made for a specific reason. These reasons include reaching age 59½, total and permanent disability, or for a first-time home purchase, subject to a $10,000 lifetime limit.

If a Roth IRA withdrawal is not a qualified distribution, the tax treatment follows specific ordering rules. The first funds withdrawn are considered your direct contributions, which are always tax-free since they were made with after-tax money. Once all your contributions have been withdrawn, subsequent amounts are treated as conversions from other retirement accounts, and finally, as earnings. These latter two categories may be subject to income tax and penalties.

Early Distribution Penalties

Distributions from a traditional IRA before you reach age 59½ are generally subject to a 10% additional tax. This is not an income tax but a separate penalty applied to the taxable portion of the early distribution. For instance, if you are in the 22% federal income tax bracket and take a $10,000 early withdrawal, you would owe $2,200 in income tax plus an additional $1,000 penalty.

The Internal Revenue Code provides several exceptions that allow you to avoid the 10% additional tax, even if you are under age 59½. These exceptions cover a range of specific financial and personal situations.

• Distributions made to your beneficiary after your death.
• Distributions taken because you have become totally and permanently disabled.
• Funds to pay for unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI).
• Using IRA funds without penalty to pay for health insurance premiums while unemployed.
• Funds withdrawn to cover qualified higher education expenses.
• A penalty-free distribution of up to $1,000 per year for certain emergency expenses.
• Distributions for the purchase of a first home, up to a $10,000 lifetime maximum.
• Withdrawals by victims of domestic abuse, up to the lesser of $10,000 or 50% of the account balance.
• Distributions taken as part of a series of substantially equal periodic payments (SEPP).
• Distributions made as a result of an IRS levy on your account.
• Distributions if you are a qualified military reservist called to active duty.

Required Minimum Distributions

The law mandates that you begin taking withdrawals, known as Required Minimum Distributions (RMDs), from traditional, SEP, and SIMPLE IRAs once you reach a certain age. The starting age for RMDs is 73. Your first RMD must be taken by April 1 of the year following the year you turn 73.

The RMD amount is calculated annually. You must divide your IRA account balance as of December 31 of the previous year by a life expectancy factor found in the IRS’s Uniform Lifetime Table. This calculation determines the minimum amount you are required to withdraw for that year. You are always permitted to withdraw more than the RMD, but the entire taxable portion will be included in your income.

Roth IRAs are not subject to RMD rules for the original account owner. This allows the funds within a Roth IRA to continue growing tax-free for your entire lifetime without any mandatory withdrawal requirements. This makes Roth IRAs a flexible tool for estate planning, as the assets can be passed to beneficiaries without the owner ever having to take a distribution.

Failing to take your full RMD by the deadline results in a penalty of 25% of the amount you failed to withdraw. For example, if your RMD for a year was $20,000 and you only withdrew $5,000, the shortfall is $15,000. The penalty would be 25% of this amount, or $3,750. This penalty can be reduced to 10% if you correct the shortfall in a timely manner.

Tax Reporting for Distributions

When you receive a distribution from any IRA, the financial institution reports the transaction to you and the IRS on Form 1099-R. This form provides details about your withdrawal, including the gross distribution amount in Box 1 and the taxable amount in Box 2a. Box 7 contains a distribution code that signifies the reason for the withdrawal, such as Code 1 for an early distribution with no known exception.

If you have ever made non-deductible contributions to a traditional IRA, you must use Form 8606, Nondeductible IRAs, to report your distributions. This form is used to track your basis, which is the total amount of your after-tax contributions. When you take a distribution, Form 8606 is necessary to calculate the taxable portion of that withdrawal according to the pro-rata rule.

You may need to file Form 5329, Additional Taxes on Qualified Plans, for penalties associated with IRA distributions. This form is used to calculate and pay the 10% additional tax on early distributions if you do not qualify for an exception. Conversely, if you meet the criteria for an exception, you file Form 5329 to claim it. The form is also used to report and pay the penalty for failing to take a required minimum distribution.