How Is an IRA Distribution Taxed? Rules and Exceptions
Withdrawing from an IRA has key tax implications. Learn how the timing of a withdrawal, contribution sources, and other circumstances affect your tax liability.
Taking money from an Individual Retirement Arrangement (IRA) is a financial event with distinct tax implications. How a distribution is taxed depends on several factors, including the type of IRA you own and your age. The tax treatment is also influenced by whether your contributions were made on a pre-tax or after-tax basis. These rules, governed by the Internal Revenue Service (IRS), determine what portion of your withdrawal is considered taxable income.
Taxation of Traditional IRA Distributions
Distributions from a Traditional IRA funded with pre-tax contributions are taxed as ordinary income upon withdrawal. When you contribute to a Traditional IRA, you can often deduct those contributions from your taxable income, providing an immediate tax benefit. Consequently, when you withdraw those funds in retirement, they are subject to income tax at your prevailing rate.
If you have made non-deductible, or after-tax, contributions to your Traditional IRA, you create a “tax basis” in your account. Since you already paid income tax on this money, you will not be taxed on it again when you withdraw it. This means a portion of your distribution will be tax-free.
When your Traditional IRA contains both pre-tax and after-tax funds, you must use the pro-rata rule. This rule dictates that each distribution consists of a proportional mix of both money types. To determine the taxable amount, you calculate the ratio of your after-tax contributions to the total value of all your Traditional IRAs.
For example, if your Traditional IRAs total $100,000 and $20,000 came from non-deductible contributions, 20% of your balance is after-tax money. If you take a $10,000 distribution, $2,000 (20%) would be a tax-free return of your basis. The remaining $8,000 would be taxable income.
You must track your basis in non-deductible contributions using IRS Form 8606. This form is filed with your tax return for any year you make a non-deductible contribution or take a distribution from an IRA with a basis. You can also choose to have income taxes withheld from the payment.
Taxation of Roth IRA Distributions
The tax treatment of Roth IRA distributions centers on the concept of a “qualified distribution,” which is entirely tax-free and penalty-free. To meet this standard, a withdrawal must satisfy two conditions. The first is that you must have held a Roth IRA for at least five years, a period that begins on January 1 of the first year you contributed to any Roth IRA.
The second condition is that the withdrawal must be for one of the following reasons:
- Reaching age 59½
- Becoming totally and permanently disabled
- The distribution is made to a beneficiary after your death
- A withdrawal of up to $10,000 for a first-time home purchase
If a distribution does not meet both requirements, it is considered non-qualified, and its tax treatment follows specific ordering rules. Under these rules, your own after-tax contributions are withdrawn first and are always tax-free and penalty-free. After you have withdrawn all of your contributions, any subsequent withdrawals are considered earnings.
These earnings are taxable as ordinary income. If you are under age 59½, these earnings may also be subject to a 10% early withdrawal penalty unless you qualify for an exception.
Early Withdrawal Penalties and Common Exceptions
Distributions from an IRA before you reach age 59½ are considered early withdrawals and are subject to a 10% additional tax. This is a penalty applied on top of any income tax you owe on the distribution. For instance, if you are in the 22% tax bracket and take an early distribution from a Traditional IRA, your total tax on that money could be 32%.
The 10% additional tax applies to the taxable portion of the distribution. For a Traditional IRA, this is the entire amount, while for a Roth IRA, it only applies to the earnings portion of a non-qualified distribution.
The IRS provides several exceptions to the 10% penalty, recognizing that individuals may face certain financial hardships. You must file Form 5329 with your tax return to claim an exception. Common exceptions include withdrawals for:
- Higher education expenses for yourself, your spouse, children, or grandchildren
- Medical expenses that exceed 7.5% of your adjusted gross income
- Withdrawals made by an individual who is totally and permanently disabled
- Distributions to pay for health insurance premiums while unemployed
- A lifetime limit of $10,000 for a first-time home purchase
Required Minimum Distributions
The government requires you to start taking annual withdrawals from your Traditional IRAs once you reach a certain age. These mandatory withdrawals are known as Required Minimum Distributions (RMDs). Roth IRAs do not have RMD requirements for the original account owner.
The SECURE 2.0 Act changed the age at which RMDs must begin. As of 2023, you must start taking RMDs at age 73. This age is scheduled to increase to 75 starting in 2033 for those born in 1960 or later. Your first RMD must be taken by April 1 of the year after you turn 73, and subsequent RMDs must be taken by December 31 each year.
The amount of your RMD is calculated annually based on the fair market value of your IRA at the end of the previous year and your life expectancy as determined by the IRS. Most IRA owners use the Uniform Lifetime Table to find their life expectancy factor. To calculate the RMD, you divide your prior year-end account balance by the distribution period factor from the table.
Failing to take your full RMD by the deadline results in a penalty of 25% of the amount that was not withdrawn. This penalty can be reduced to 10% if you correct the shortfall within a two-year window. Given the substantial penalty, it is important to manage RMD obligations each year.
Tax Rules for Inherited IRAs
When you inherit an IRA, the tax rules depend on your relationship to the original owner, with different regulations for spousal and non-spousal beneficiaries.
Spousal Beneficiaries
A surviving spouse who inherits an IRA has flexible options. The most common choice is to treat the inherited IRA as their own by rolling the assets into a new or existing IRA. As the new owner, the spouse can delay withdrawals until they reach RMD age, allowing the funds to continue growing tax-deferred.
Alternatively, a spouse can remain a beneficiary of the IRA. If the deceased spouse had already started taking RMDs, the surviving spouse must continue taking them. If the original owner had not yet reached RMD age, the spouse can delay distributions until the original owner would have turned 73.
Non-Spousal Beneficiaries
For most non-spousal beneficiaries, the rules are more restrictive. Following the SECURE Act, most non-spouse beneficiaries are subject to the “10-year rule,” requiring them to withdraw all assets from the account by the end of the 10th year after the owner’s death.
Whether annual distributions are required during this 10-year period depends on if the original owner had started taking RMDs. If the owner died before their RMDs began, the beneficiary only needs to empty the account by the end of the 10th year. However, if the owner had already started taking RMDs, the beneficiary must also take annual distributions for years one through nine, with the full balance withdrawn by the end of the 10th year.
Distributions from an inherited Traditional IRA are taxed as ordinary income to the beneficiary, while qualified distributions from an inherited Roth IRA are tax-free. Beneficiaries cannot make new contributions to an inherited IRA.