IRA and Taxes: Key Rules for Your Retirement Savings

An Individual Retirement Arrangement, known as an IRA, is a personal savings plan that offers tax advantages for retirement funds. These accounts are established by individuals through financial institutions like banks or brokerage firms. The function of an IRA is to provide a tax-favored environment for savings to grow, supplementing other retirement income sources.

Tax Implications of IRA Contributions

When funding an IRA, the tax implications are determined by whether you choose a Traditional or a Roth IRA. Contributions to a Traditional IRA may be tax-deductible, which can lower your taxable income for the year. This deduction is subject to conditions based on your income and whether you or your spouse have a workplace retirement plan, such as a 401(k).

If you are covered by a workplace plan, the deductibility of your Traditional IRA contribution is phased out based on your Modified Adjusted Gross Income (MAGI). For single filers, this phase-out range is between $79,000 and $89,000. For those married filing jointly where the contributing spouse has a workplace plan, the range is $126,000 to $146,000. If you are not covered by a workplace plan but your spouse is, the phase-out range for a joint return is $236,000 to $246,000.

In contrast, contributions to a Roth IRA are never tax-deductible because they are funded with after-tax dollars. The ability to contribute to a Roth IRA is also limited by your MAGI. The income phase-out range for single filers and heads of household is $150,000 to $165,000, and for married couples filing jointly, it is $236,000 to $246,000. If your income exceeds these limits, you cannot contribute directly to a Roth IRA.

If your income is too high for deductible Traditional or any Roth IRA contributions, you can make nondeductible contributions to a Traditional IRA. While you receive no upfront tax deduction, these contributions have a different tax treatment upon withdrawal. The maximum annual contribution to all of your IRAs combined is $7,000, or $8,000 if you are age 50 or older.

Tax Treatment of IRA Withdrawals

The tax rules for taking money out of an IRA differ between Traditional and Roth accounts. Distributions from a Traditional IRA are included in your taxable income, as contributions were often pre-tax and earnings grew tax-deferred. The withdrawals are taxed at your ordinary income tax rate for the year you take the distribution.

A “qualified distribution” from a Roth IRA is tax-free. To be considered qualified, the withdrawal must meet two conditions: you must have held a Roth IRA for at least five years, and you must meet a qualifying reason. The most common qualifying reason is reaching age 59½, but others include total and permanent disability or death.

For both types of IRAs, a 10% additional tax is applied to early distributions. If you withdraw funds before reaching age 59½, the taxable portion of that withdrawal is subject to this penalty on top of any regular income tax owed.

There are several exceptions to this 10% additional tax. Common exceptions include:

• Using the funds for a first-time home purchase, with a lifetime limit of $10,000.
• Paying for qualified higher education expenses for yourself, your spouse, children, or grandchildren.
• Taking distributions due to total and permanent disability.
• Paying for health insurance premiums while unemployed.
• Covering certain medical expenses exceeding 7.5% of your adjusted gross income.

Required Minimum Distributions

A Required Minimum Distribution, or RMD, is the amount of money that must be withdrawn annually from certain retirement accounts, including Traditional, SEP, and SIMPLE IRAs. The RMD rule ensures that individuals eventually pay taxes on their tax-deferred retirement savings.

Original owners of Roth IRAs are not subject to RMDs during their lifetime. This allows the funds within a Roth IRA to continue growing tax-free for the owner’s entire life.

RMDs must begin for the year in which you turn age 73. You can delay your first RMD until April 1 of the year following the year you turn 73. However, if you choose this option, you will have to take two RMDs in that second year: one for the year you turned 73 and another for the current year. All subsequent RMDs must be taken by December 31 of each year.

The RMD amount is calculated each year by dividing the IRA’s prior year-end fair market value by a life expectancy factor from the IRS’s Uniform Lifetime Table. Failing to take the full RMD by the deadline results in a 25% tax penalty on the amount that was not withdrawn. This can be reduced to 10% if the mistake is corrected in a timely manner.

Special IRA Tax Situations

Rollovers

A rollover is the movement of funds from one retirement account to another. In a direct, or trustee-to-trustee, rollover, the financial institution sends the money directly to the new IRA custodian. This method avoids tax withholding and potential complications.

An indirect rollover occurs when the funds are paid directly to you. You have 60 days from the date you receive the funds to deposit them into another eligible retirement plan. If you miss this 60-day deadline, the entire amount may be treated as a taxable distribution and could be subject to the 10% early withdrawal penalty. For rollovers from employer plans like a 401(k), the distributing institution must withhold 20% for taxes.

Roth Conversions

A Roth conversion is the process of moving funds from a Traditional, SEP, or SIMPLE IRA into a Roth IRA. Anyone can convert funds to a Roth IRA, regardless of their income level. The amount you convert is included in your taxable income for the year of the conversion, which applies to any pre-tax contributions and all investment earnings.

The decision to convert involves paying taxes on your retirement savings now in exchange for tax-free withdrawals in the future. If you have made nondeductible (after-tax) contributions to your Traditional IRA, that portion of the conversion is not taxed. The taxability of the conversion is calculated on a pro-rata basis, considering all of your Traditional IRA assets.

Inherited IRAs

When an IRA owner dies, the account is passed to a beneficiary, and specific tax rules apply. The rules differ depending on whether the beneficiary is a surviving spouse or a non-spouse. A surviving spouse has the most flexibility, often with the option to treat the inherited IRA as their own by rolling it into their existing IRA. This allows them to follow the standard rules for distributions based on their own age.

Most non-spouse beneficiaries are subject to the 10-year rule. This rule requires the beneficiary to withdraw the entire balance of the inherited IRA by the end of the 10th year following the year of the original owner’s death. There are exceptions for certain “eligible designated beneficiaries,” such as minor children of the original owner or disabled individuals, who may be able to take distributions over their life expectancy.

Reporting IRA Activity on Your Tax Return

All IRA transactions must be correctly reported to the IRS on your annual income tax return. Financial institutions report these activities using specific forms that you and the IRS will receive.

If you took any money out of your IRA during the year, you will receive Form 1099-R. This form reports the gross distribution amount and will indicate if any of it is potentially taxable. It is used to report regular withdrawals, Roth conversions, and rollovers.

Contributions to an IRA are reported by your financial institution on Form 5498. This form shows the amount of contributions you made for the year, including any rollover contributions or Roth conversions. You receive this form in May, as it includes contributions made for the prior year up until the tax filing deadline.

For certain transactions, you must file Form 8606. This form is used to report nondeductible contributions to Traditional IRAs, track your total basis in your IRAs, report Roth conversions, and determine the taxable amount of your IRA distributions. When filing your tax return, you will report any deductible IRA contributions on Schedule 1 of Form 1040, and the total taxable amount of your IRA distributions is reported directly on Form 1040.