Concerned about overpaying taxes on your Individual Retirement Account (IRA) distributions? It's a valid worry but one that you can address if you have the right information. First, you need to know whether the money you're withdrawing was paid in as pre-tax or post-tax money, or a mix of the two. Keeping good records is key.
Key Takeaways
- Contributions to a traditional IRA are made with pre-tax money, meaning that the funds in your account will not be taxed until they are paid out.
- Contributions to a Roth IRA are made with post-tax money, meaning you pay the tax due on the money in the year you pay it in. That money, including the earnings that accrue, won't be taxed again when you withdraw it properly.
- If you convert a traditional IRA to a Roth IRA, you'll pay the taxes owed on the balance in the year that you make the conversion. It won't be taxed again when you withdraw it properly.
- Some people (mostly high earners) have pre-tax and post-tax money in their retirement accounts. If so, it's up to them to determine what portion is taxable and what portion isn't when they file their taxes.
Income Levels and IRAs
Contributions to a traditional IRA are usually tax-deductible in the year in which the money is paid in. That is one of the main benefits of an IRA: The saver gets an immediate tax break, by reducing that year's taxable income while putting the money away for a distant future. The money will be taxed only when it is withdrawn as retirement income.
However, contributions to a traditional IRA are not tax-deductible for everyone. The exception is for high earners who contribute to both a 401(k) retirement plan in their workplace and a traditional IRA purchased through a bank or brokerage. In that case, those with income above a threshold amount that is adjusted annually for inflation can no longer deduct contributions from a traditional IRA.
Contributions to a Roth IRA are always made with post-tax income. Unfortunately, if your income exceeds certain levels, you can’t contribute directly to a Roth. But you can keep any existing Roth IRA you have and you can convert money from a traditional IRA to a Roth IRA, regardless of your income level.
Even when IRAcontributions are not deductible,there are good reasons to make them. They increase your retirement savings, and the earnings on the contributions are tax-deferred. (Keep in mind that the annual contribution limit to an IRA is the same whether you make deductible contributions or nondeductible after-tax contributions.)
Traditional IRAs and Taxes
When you make tax-deductible contributions to a traditional IRA, the funds in your account won’t be taxed until you take them out as a distribution or convert them to a Roth IRA.
However, if your IRA was built in part with nondeductible contributions, you don’t owe tax on that money when it is distributed or converted, as it has already been taxed.
You might think that you could just say that the funds you distributed or converted came from the nontaxable money in your accounts, but the law doesn’t allow you to do that. Instead, you must compute the total percentage of nontaxable funds in your accounts and then apply it to the amount of the distribution or conversion.
Be sure to keep a running total of all your after-tax IRA contributions from year to year.
You need to do this even if the IRA from which you are taking the distribution has only nondeductible contributions in it. This requires keeping good records of what you contributed to your IRA on an after-tax basis.
When you make a nondeductible IRA contribution, report it on Form 8606, Nondeductible IRAs. Enter any nondeductible contribution you make for the current year and add that to your nondeductible contributions in prior years (minus adjustments for distributions) to get the total basis across all your traditional IRAs.
This information helps you to figure out the tax on distributions and conversions. Be sure to retain copies of Form 8606, so you’ll have cost basis information for the future. Don’t assume that your IRA custodian or trustee will track this information for you.
How to Figure out Your Tax Amount
When you have both types of traditional IRAs (those with tax-deductible contributions and those with after-tax ones), figuringout how much of your distribution or conversion is taxable is a complicated process.
As noted above, you cannot designate on your tax form that your traditional IRAdistributions or conversions are coming solely from your after-tax contributions. Instead, you must figure out the percentage that nondeductible contributions account for in the total balance of all your accounts.
Divide the total amount of your nondeductible contributions by the value of all your IRA accounts (including SEP IRAs and SIMPLE IRAs) as of the end of the year. Be sure to include in that value the distribution or conversion you are making as well as any others you've made during the year.
If, for example, you contributed $10,000 in after-tax money over the years to all of your IRAs and the balance in all of your accounts plus the distribution you are taking is $100,000 ($90,000 account balance plus a $10,000 distribution), your percentage would be 10% ($10,000 divided by $100,000).
That 10% is the tax-free percentage of your IRA distribution.
Now multiply the distribution for the year ($10,000) by this percentage to determine what amount is tax-free ($1,000) and what amount is taxable ($9,000).
If you take a distribution before age 59½, you’re subject to a 10% penalty only on the taxable portion of the distribution (assuming no penalty exception applies). The 10% penalty does not apply to the tax-free portion of the distribution. In the case of the example above, you would pay a $900 penalty (10% of $9,000).
Are Losses on a Roth IRA Tax Deductible?
No, the IRS does not permit you to deduct a loss on a Roth IRA: the only way to deduct your losses is to close your Roth IRA accounts. The ability to deduct losses in any type of IRA accounts ended in 2018, due to the Tax Cuts and Jobs Act (TCJA).
Frequently Asked Questions
At What Age Can I Withdraw Money From My IRA Without Paying a Penalty?
You can withdraw money from a traditional IRA at age 59 1/2 or later without paying a penalty. You will owe income taxes on the entire amount for that year.
If you have a Roth IRA, you can withdraw the money you contributed at any time as long as the account has been open for at least five years. You already paid the income taxes, so you won't owe more. You cannot take any of the earnings that have accrued early without paying the taxes due and a penalty unless you qualify for an exception to the usual rules.
Once you are 59 1/2, you can take money out of your Roth IRA without paying taxes on any part of it. If it is a traditional IRA, you'll owe taxes on the entire amount withdrawn.
Do You Pay Taxes on IRA Withdrawals After 65?
The tax rules stay the same from when you're 59 1/2 until you're 110 or more. You'll owe income taxes on all of the money you withdraw from a traditional IRA. You should owe no taxes on the money you withdraw from a Roth IRA.
Are IRA Withdrawals Considered Income for Social Security?
Withdrawals from a traditional IRA are taxable income and count as part of your "combined income" for Social Security purposes. If you have a Roth account, you already paid the taxes due at the time you deposited the money. So, you should not owe taxes on the withdrawal and it will not add to your taxable income.
You pay income taxes on a portion of your Social Security benefits if your "combined income" exceeds a certain level. Combined income is defined as adjusted gross income, tax-exempt interest income, and half of your Social Security income.
The threshold for taxing your Social Security income is very low: $25,000 for individuals and $32,000 for a couple.
The Bottom Line
There are some very good financial reasons to make nondeductible IRA contributions, but doing so complicates your tax life. Be sure to keep records so you won’t pay tax on these contributions again when you take distributions or make Roth IRA conversions. And if math isn’t your strong suit, consider having a tax professional figure out what you owe.
Correction—Jan. 28, 2023: A previous version of this article stated erroneously that income from an Individual Retirement Account is excluded from the combined income total that is used to determine taxes on Social Security benefits.
Correction—March 26, 2023: A previous version of this article stated that you can't have a Roth IRA if your income exceeds certain levels: although in this situation you can't contribute directly to a Roth IRA, you can keep an existing Roth and/or convert money from a traditional IRA to a Roth IRA.
