Distributions from different IRAs are affected by different tax rules. This can be confusing when it’s time to start taking withdrawals from these retirement accounts, and making an error can have costly consequences.
Here is a look at the tax treatment of IRA distributions.
Generally, a distribution from a traditional IRA is subject to income taxes at ordinary income tax rates. However, there are some exceptions. Additionally, there could be penalties involved.
Money contributed to an IRA account on a pre-tax basis will be subject to income taxes when withdrawn. This includes money rolled over from a workplace retirement plan that was contributed on a pre-tax basis as well.
An exception to this is money contributed to an IRA on an after-tax basis, including money rolled over from a qualified retirement plan that was originally contributed after tax. The key here is to keep track of these contributions and complete the appropriate paperwork when these funds are distributed to ensure you don’t needlessly pay tax on them.
Penalties on Withdrawals
If you are younger than 59½, distributions of pre-tax money from a traditional IRA account will be subject to a 10% penalty in addition to the income tax due. There are some exceptions where the penalty will not apply, which include:
- A distribution taken to cover eligible college expenses.
- A distribution of up to $10,000 or up to $20,000 for a married couple to buy, build or rebuild one’s first home or that of qualified family members.
- Distributions to cover unreimbursed medical expenses that exceed the adjusted gross income threshold.
- Distributions taken following a period of unemployment to cover the cost of health insurance for yourself, your spouse and your dependents.
- Distributions taken in connection with a disability, but you will need to furnish proof of the disability.
- Distributions to cover the payment of an IRS tax levy.
- Members of the military who are on active duty can take penalty-free distributions, subject to the appropriate rules.
- Inheriting an IRA prior to age 59½ allows the heir to take distributions without incurring the penalty. However, if the IRA is left to a spouse and he or she makes the IRA their own, then any subsequent withdrawals prior to age 59½ would be subject to the penalty as normal.
- You can set up a series of substantially equal periodic payments from your IRA account if you are under age 59½. If the rules are followed, this series of account distributions are not subject to the penalty. This falls under the 72(t) rules, which are ungodly complex. Many custodians do not fully understand them; if you want to go this route you should consider seeking guidance from a financial or tax professional who understands the rules. Making a mistake can potentially be quite costly.
IRA Account Rollovers
Rolling over your IRA from one custodian to another can be done without incurring taxes –- or penalties for those under age 59½ — once per every 12-month period.
This rule applies to the 60-day rollover period from one IRA to another. Under this rule if you take a distribution from an IRA account, you have 60 days to roll this money over to another IRA account. This covers all of your IRAs including SIMPLE IRAs, SEPs and Roth IRAs, as well as your traditional accounts.
Violating this rule can have severe consequences. An excess rollover can be deemed a taxable distribution and can trigger both unwanted taxes and penalties if applicable.
Trustee-to-trustee transfers are not subject to this rule, and this is the most efficient way to do this anyway. This would typically be initiated by the new custodian who will be receiving the money. They will have you complete a form and provide a recent statement from the account the money will be transferred from. This is definitely the way to go if you are looking to move your account from one custodian to another.
Conversions from a traditional IRA to a Roth IRA are also not impacted by this rule.
Roth IRA distributions are not taxable as long as your initial Roth contribution was made at least five years ago and you are at least 59½ years old. This five-year period begins with the first contribution to any Roth IRA set up for your benefit.
In addition, qualified Roth distributions that are not subject to taxes include:
- A beneficiary receiving the account proceeds as a result of the account holder’s death.
- The distribution is $10,000 or less and will be used for the purchase, building or rebuilding of your first home or that of qualified family members.
Exceptions where money can be withdrawn without paying taxes or incurring a 10% penalty include:
- The withdrawal of your contributions; this is the amount contributed with no investment gains included.
- The distributions are part of a series of substantially equal payments, minimum five years or until the Roth IRA owner reaches age 59½, whichever is longer.
- Unreimbursed medical expenses exceeding adjusted gross income threshold.
- Payment of medical insurance premiums after losing your job.
- Distributions up to the amount of qualified higher education expenses for yourself or eligible family members.
- The distribution is due to an IRS levy.
- The distribution is a qualified military reservist distribution.
An IRA is a great retirement savings vehicle for both contributions and for funds rolled over from an old employer retirement plan. There are potential tax implications for distributions from all varieties of IRA accounts, and it is important you understand these to avoid inadvertently triggering an unwanted tax bill.