How Are Traditional IRA Withdrawals Taxed?

When you take withdrawals from your traditional IRA, you probably understand they’re taxable. But what does that really mean?

Important: Once you reach a certain age, you must start taking required minimum distributions (RMDs) from your traditional IRAs or you will be hit with an expensive tax penalty. Previously, the required beginning date (RBD) was April 1 of the year after the year in which you turn 70½. However, the Setting Every Community Up for Retirement Enhancement (SECURE) Act pushed back the RBD to 72 for individuals who reach 70½ after 2019. Contact your tax advisor for more information.

Where to Begin

To determine the federal income tax consequences of an IRA withdrawal, the first step is to identify how many traditional IRAs you have. You likely have the ones with the largest balances top-of-mind, but don’t overlook:

• Any rollover IRAs set up to receive distributions from former employers’ retirement plans, and
• Any SEP-IRAs or SIMPLE-IRAs set up in your name.

If you have several traditional IRAs, you must take the cumulative total and treat them as one account to determine the tax consequences of taking withdrawals from any of them. However, if your spouse owns an IRA, it doesn’t affect the taxability of your IRA withdrawals.

Important: If you withdraw any funds from an IRA this year, you’ll receive a Form 1099-R from your IRA trustee or custodian in early 2022. A copy of any Form 1099-R is sent to the IRS as well, so be sure to report it on your 2021 federal tax return.

Taxability if No Nondeductible Contributions Made

If you haven’t made any nondeductible contributions, all withdrawals are 100% taxable, regardless of how many IRAs you have. And you must include them in your taxable income for the year you take them. If you take any withdrawals before age 59½, they’ll be hit with a 10% penalty tax unless an exception applies. (See “How to Avoid the Early Withdrawal Tax Penalty” below.)

The Situation Changes if You’ve Made Nondeductible Contributions

If you’ve made at least one nondeductible contribution over the years, the contribution amounts will create tax basis in your account, and each withdrawal from your traditional IRA will include some amount of basis. That amount is tax-free; the remainder is taxable and is handled in the manner previously explained.

To calculate tax-free basis amounts and taxable amounts, you create a fraction. The numerator equals your cumulative nondeductible contributions to all your IRAs as of the end of the year. The denominator equals the combined balances of all your IRAs on that date plus all withdrawals taken during the year.

For example, as of December 31, 2021, you’ve made $18,000 in nondeductible contributions to your two traditional IRAs. You also have a rollover IRA that was funded with a distribution from your former employer’s 401(k). During 2021, you withdraw $28,000. It doesn’t matter which account (or accounts) the money came from. On December 31, 2021, the three accounts are worth $272,000 combined.

The numerator of your fraction is $18,000. The denominator is $300,000 ($272,000 + $28,000). So, the tax-free basis portion of your 2021 distribution is $1,680 [($18,000 / $300,000) times $28,000]. The remaining $26,320 ($28,000 minus $1,680) is taxable in 2021. If you’re under 59½, you may also owe the 10% early withdrawal penalty tax.

For More Information

As you can see, the tax rules get complicated if you’ve made nondeductible contributions. Fortunately, you don’t have to file the required tax forms by yourself. Contact us <link to contact page> to help you understand how withdrawals from your traditional IRA will affect your tax situation.

How to Avoid the Early Withdrawal Tax Penalty

The taxable portion of a withdrawal from a traditional IRA prior to age 59½ is generally subject to a 10% early withdrawal penalty tax in addition to the regular income tax hit. But there are several exceptions to the penalty tax, including:

• Paying for medical costs greater than 7.5% of your adjusted gross income,
• Taking annuity-like annual withdrawals under IRS guidelines,
• 2020 withdrawals that qualified as coronavirus-related distributions,
• Withdrawals up to the amount of qualified higher education expenses for you, your spouse, or the children or grandchildren of you or your spouse, and
• Withdrawals to buy or build a first home for a parent, grandparent, yourself, a spouse, or you or your spouse’s child or grandchild. This exception for first-time home purchases is subject to a lifetime limit of $10,000. A first-time homebuyer is someone who hasn’t had an ownership interest in a home in the last two years before buying a new home.

Your tax advisor can tell you if you’re eligible for these or any other exceptions to the 10% early withdrawal penalty tax.