Most Americans use IRAs to ensure they have enough funds in preparation for their retirement. Aside from being tax-favored, it also has a lot of benefits which makes it easier for anyone to save sizable retirement funds. When it’s time to enjoy the fruits of your labor, it’s important to take into considerations the tax implications of withdrawals from IRAs as well as how to properly report those distributions on your tax returns.
As a general rule, the IRS requires you to report the total amount of money you received from IRAs during the taxable year but you’ll also have to report what portion of the funds is taxable and which is not. IRS rules are pretty straightforward but still, having more knowledge will save you from future headaches when it comes to filing your tax returns.
IRA Taxation 101
The first thing to consider to know what part of your IRA distribution is taxable is to know what type of IRA you took the money from.
Funds from a traditional IRA is taxable.
The reason behind this is that for traditional IRAs, most people get an up-front tax deduction which means that the funds you put into your retirement account are pre-tax money. Since neither the contributed amount nor the income and gains on those contributions were not subject to tax, the IRS will then get a portion out of it once you withdraw money from this retirement fund.
Funds from Roth IRA isn’t taxable.
On the other hand, Roth IRA isn’t taxable because you don’t get an up-front deduction. This means you have to use after-tax money to fund your retirement account. Due to this, the rule regarding Roth IRA states that the income and gains from those contributions are tax-free.
As the saying goes, “In every rule, there is at least one exception”. This is true when it comes to dealing with tax concerns. In some cases, different tax treatment needs to be observed for traditional and Roth IRA as deemed necessary.
Traditional IRAs distributions may be partially taxable if you’ve made non-deductible contributions to your IRA in the past.
When it comes to Roth IRAs, it can also be partially taxable if you don’t meet some governing rules about them namely;
- Withdrawals before age 59 ½ which don’t qualify for exceptions will invalidate the tax-free treatment of earnings from Roth IRA.
- If you’re older than 59 ½ but you’ve had your Roth IRA for less than 5 years, then the same provision will apply.
It’s important to note though that the rules for determining the taxable amount will be different for the above because it will be treated as taking your initial contributions on a tax-free basis before you tap any potentially taxable earnings from your Roth IRAs.
IRAs are certainly a great way to save up for your much-deserved retirement. But they can be subject to big tax consequences once you started taking withdrawals so it’s VERY important that you know exactly what to expect. This will allow you to be in a better position to make smart tax planning as well as to use your IRAs wisely. Congratulations on your retirement and enjoy!