The way individual retirement account (IRA) withdrawals are taxed depends on the type of IRA. You'll pay tax on withdrawals from a traditional IRA, but with a Roth IRA, there is no tax due at withdrawal on either contributions or earnings, provided you meet certain requirements.
In general, early withdrawals—before age 59½—from any type of qualified retirement account, such as IRAs and 401(k) plans, come with a 10% penalty, as well as any income taxes due, though there are some exceptions to this rule.
Both traditional and Roth IRAs are subject to the same annual contribution limits. The limit is $6,000 for 2020 and 2021. If you are 50 or older, you can contribute an additional $1,000, which is known as a catch-up contribution.
- Contributions to traditional IRAs are tax-deductible, earnings grow tax-free, and withdrawals are subject to income tax.
- Contributions to a Roth IRA are not deductible, but withdrawals are tax-free if the owner has had a Roth IRA account for at least five years.
- Because contributions to Roth IRAs are made with after-tax money, they can be withdrawn at any time, for any reason.
- Early withdrawals (before age 59½) from a traditional IRA—and withdrawals of earnings from a Roth IRA—are subject to a 10% penalty, plus taxes, though there are exceptions to this rule.
How Traditional IRA Withdrawals Are Taxed
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 (not capital gains), and the tax rate is based on your income in the year of the withdrawal.
The idea is that you are subject to a higher marginal income tax rate while you are working and earning more money than when you have stopped working and are living off of retirement income—although this is not always the case.
Traditional IRA holders (and 401(k) plan participants, too) who are 72 years and older must withdraw minimum amounts, called required minimum distributions (RMDs), which are subject to taxation. RMDs used to start at 70½, but the age was lifted following the December 2019 passage of the Setting Every Community Up For Retirement Enhancement (SECURE) Act.
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 withdrawal include a first-time home purchase, qualified higher education expenses, qualified major medical expenses, certain long-term unemployment expenses, or if you have a permanent disability.
In 2020, an individual with a MAGI between 65,000 and $75,000 is eligible for at least partial deductibility, as is a married couple filing jointly with a MAGI of between $104,000 and $124,000. For 2021, the MAGI for individuals is $66,000 to $76,000, and for married couples filing jointly, it's $105,000 to $125,000. There are no income limits on who can contribute to a traditional IRA.
How Roth IRA Contributions Are Taxed (or Not)
Because contributions to Roth IRAs are made with after-tax dollars, you can withdraw them tax-free at any time, for any reason. But this also means they are not tax-deductible as contributions to a traditional IRA can be.
You can withdraw earnings without penalties or taxes as long as you’re 59½ or older and you have had a Roth IRA account for at least five years. Although it can be hard to predict, if you think you will be in a high tax bracket when you retire, a Roth IRA may be a good choice.
You can only contribute earned income to a Roth IRA.
Like a traditional IRA, you can avoid the 10% penalty for withdrawals if the money is used for a first-time home purchase, qualified education expenses, medical expenses, or if you have a permanent disability. You'll still pay taxes on the amount withdrawn, though.
Not everyone is eligible to contribute to a Roth IRA. Unlike a traditional IRA, there are income limits. In 2021, only individuals with a modified adjusted gross income (MAGI) of $140,000 ($139,000 for 2020) or less are eligible to participate in a Roth IRA. The phase-out for singles starts at $125,000 ($124,000 for 2020). For those married filing jointly, the 2021 MAGI limit is $208,000 ($206,000 for 2020), with a phase-out starting at $198,000 ($196,000 for 2020). If you earn too much to contribute to a Roth directly, you might be able to make contributions indirectly via a strategy known as a backdoor Roth IRA.