The way in which individual retirement account (IRA) withdrawals are taxed depends on the type of IRA. With a Roth IRA, there is no tax due at withdrawal on either contributions or earnings, provided you meet certain requirements: the account must have been active for at least five years, and either the funds are used for a qualified home purchase or the account holder is 59½ years of age or older.

Early withdrawals from any type of qualified retirement account come with a 10% penalty, as well as any income taxes due on traditional IRAs and 401(k)s - unless the early withdrawal is for a qualified purpose, such as buying a first home or education expenses.

Key Takeaways

  • Withdrawals from traditional IRAs or 401(k) accounts after age 59 1/2 are subject to income tax based on the tax rate corresponding to the year the withdrawal is taken out.
  • Roth IRA withdrawals made after age 59 1/2 are received income-tax-free.
  • Early withdrawals from any retirement account are subject to a 10% penalty, plus any deferred taxes owed for traditional accounts - unless early withdrawals are taken for a qualified exempt purpose.

What Happens When You Withdraw

With a traditional IRA, any pre-tax contributions and all earnings are taxed at the time of withdrawal. The withdrawals are taxed as regular income (and not capital gains tax), and the tax rate is based on your income in the year of the withdrawal. The idea is that people are subject to a higher marginal income tax rate while they are working and earning more money than when they have stopped working and are living off of retirement income - although this is not always the case.

Although taxes are assessed at the time of withdrawal, there are no additional penalties, provided that the funds are used for a qualified purpose or that the account holder is 59½ years of age or older. With a traditional IRA, qualified purposes for an early fund withdrawal include a qualified home purchase, qualified higher education expenses, qualified major medical expenses and certain long-term unemployment expenses.

Traditional IRA holders (or 401(k) plan participants) age 70 1/2 or over must withdraw minimum amounts called required minimum distributions (RMDs), which are subject to taxation.

Roth IRA Contributions Are Not Tax Deductible

As withdrawals from Roth IRA accounts are not taxed, Roth IRA contributions are not tax deductible. However, only individuals with a modified adjusted gross income (MAGI) of $135,000 or less are eligible to maximize the annual Roth IRA contribution limit in 2018. The phaseout for singles starts at $120,000. For married filing jointly, the 2018 MAGI limit is $199,000 with a phaseout starting at $189,000. 

The 2019 MAGI limit for Roth IRA contributions is $137,000 for singles with a phaseout starting at $122,000. For those married filing jointly, the MAGI limit is $203,000 with a phaseout starting at $193,000. Any additional contributions would be placed in a traditional IRA. 

Thus, withdrawals made from a Roth IRA during retirement are not subject to income tax since the funds grew tax-exempt using after-tax dollars.

Contribution Limits for Traditional Roth IRAs

The contribution limits for traditional and Roth IRAs is hiked up to $6,000 in 2019 from $5,500 in 2018, according to the IRS. Employees age 50 or older are permitted to make a catch-up contribution of an additional $1,000 for a total of $7,000. Traditional IRA contributions can be tax deductible or partially tax deductible based on MAGI for people who are covered by a 401(k) plan by their employer. In 2019, an individual with a MAGI of up to $74,000 (up from $73,000 in 2018) is eligible for at least partial deductibility, as is a married couple filing jointly with a MAGI of up to $123,000 (up from $121,000 in 2018). There are no income limits on who can contribute to a traditional IRA.