How IRA distributions are taxed?

When saving for retirement, you should consider the amount of taxes you will pay on your retirement savings. Some retirement plans allow retirement savers to defer paying taxes and only pay taxes when taking a distribution, while other retirement accounts allow retirement savers to pay taxes upfront and take tax-free distributions in retirement.

The tax you pay on retirement distributions depends on the type of IRA you have. For a traditional IRA, you will pay income tax on the distributions you take, and a 10% early withdrawal penalty if you are below 59 ½. If you have a Roth IRA, you will not pay tax when you withdraw contributions or investment gains, as long as you are above 59 ½ and the account is at least five years old since it was opened.

Tax on Traditional IRA distributions

When you contribute to a traditional IRA, you get a tax break on the contributions, and every dollar you contribute reduces the taxable income for the year. The money grows tax-deferred over your working years, and you will only pay taxes at the time of withdrawal.

When you withdraw money from the IRA, you will pay tax on both the contributions and gains earned in the account at your income tax rate for the year. The withdrawals are taxed as regular income, and at your tax bracket rate. If you withdraw funds before reaching age 59 ½, you will pay a 10% penalty for early withdrawal in addition to the regular income taxes.

Withdrawals before age 59 ½ may be exempted from the 10% penalty if the funds are used to pay for qualified expenses such as unreimbursed medical expenses, higher education expenses, or buying a first-time home.

Tax on Roth IRA Distributions

Since a Roth IRA is funded with after-tax dollars, you won’t pay taxes when you take a qualified distribution. For a withdrawal to be considered qualified, you must be at least age 59 ½ or older, and the account must have been held for at least five years. Also, you can withdraw the contributions (but not the investment gains) at any time without owing taxes.

If the Roth IRA does not meet the criteria for qualified distributions, it is considered a non-qualified distribution, and you will pay taxes on any investment gains that you withdraw. The withdrawal may also be subject to a 10% penalty if you are below age 59 ½ at the time of the withdrawal. You can be exempted from the 10% penalty if you are using the funds to pay for qualified expenses such as qualified education expenses, first-time home purchase, and medical expenses.

IRA Required Minimum Distributions

Once you retire, you can decide to leave your IRA funds untouched until when you attain the RMD age. The IRS requires retirement savers to start taking the mandatory distributions from their IRA when they reach age 72.

The IRS provides guidelines on how much you can withdraw each year, depending on your age. If you don't take the required distribution, the IRS imposes a 50% penalty on the amount of distribution you did not take. However, you are allowed to take more than the required distribution amount.

You will pay income taxes on the distributions in the year when they occur. If you die and your beneficiaries inherit the IRA, they will be required to pay taxes on the distributions they take.

If you have a Roth IRA, you won’t be required to take RMDs when you reach age 72. You can leave the Roth IRA funds untouched over your lifetime without risking a penalty. However, you can decide to take tax-free distributions at any time, as long as you've held the account for at least five years and you are age 59 ½ or older.

Do Beneficiaries Pay Tax on Inherited IRA distributions?

If an IRA owner dies, the designated beneficiaries will inherit the IRA funds. The beneficiaries will pay ordinary tax on the distribution if the deceased owed taxes on the money. However, the beneficiaries won’t owe a 10% early withdrawal penalty, regardless of the deceased’s or beneficiary’s age.

If you inherit an IRA from a parent, you must take the full distribution within 10 years from the date of the account owner’s death. You can spread distributions over the 10 years period or take a lump-sum distribution as long as you take the full distribution by the 10th year. You must pay income taxes on every distribution you take.  

If you are a spouse of the deceased IRA owner, you have more options with the money. You can treat the inherited IRA as your own, rollover to your IRA, or even stretch distributions over your lifetime.