While Social Security may provide some retirement income, those benefits alone cannot guarantee a comfortable retirement for most people. That’s why planning for your retirement is a must. An IRA is a valuable investment tool for retirement, but many clients want to know how IRA withdrawals get taxed during retirement.
Understanding the IRA and how it works
An Individual Retirement Account, or IRA, is simply a type of investment account that has various tax advantages. With IRAs, you are not required to pay any taxes on earnings from the account. Instead, your earnings are reinvested and compounded to allow your account to continue to grow. Once you reach retirement age, you can begin to make withdrawals from your IRA, at which time you will pay taxes depending on the type of IRA you have, the amount of your income, and the amount you withdraw.
How are traditional IRAs taxed?
When you make contributions to a traditional IRA, you do not pay taxes on those contributions, nor on the interest your account earns. Until you start taking withdrawals during retirement. In other words, a traditional IRA is funded with “pre-tax” dollars, and when you start withdrawing funds those withdrawals are taxed as ordinary income. So, if your income is taxed at 20%, and you take a withdrawal of $10,000, you will owe $2,000 in income taxes on that withdrawal.
Roth IRAs are taxed differently
Roth IRAs are taxed in a completely different manner. They are funded with “after-tax” dollars, so there are no tax benefits for contributions. Instead, the earnings and withdrawals are basically free. Essentially, with a Roth IRA, you avoid taxes when you make withdrawals, but with traditional IRAs, you avoid taxes when making your contributions.
Early withdrawals from a traditional IRA
The IRS charges a penalty for early withdrawals and distributions, regardless of the type of IRA. Traditional IRAs require an additional 10% penalty if you receive a distribution prior to reaching the age of 59½. However, with a Roth IRA, you are allowed to withdraw your initial contributions at any time, without paying a penalty, because you have already paid income taxes. But, early withdrawals of earnings on the retirement funds are subject to the 10% penalty. The Roth IRA also requires that in order to begin taking withdrawals without penalty, you must have reached age 59½ and the IRA must have been established for at least five years before the first draw.
Consider converting to a Roth IRA
If you have a traditional IRA or employer-sponsored retirement plan, you do have the option of converting those accounts to a Roth IRA. Making the conversion is quite easy, especially if you understand how to convert to a Roth IRA. You can choose to transfer some or all of your existing retirement account balance to your new Roth IRA, regardless of income. Converting a traditional IRA to a Roth IRA can be a smart option, particularly when you expect your tax rate to increase. When your earnings are too high to allow you to contribute to a Roth IRA, you can use a Roth conversion to accomplish the same tax free benefits.
If you have questions regarding IRAs, or any other retirement planning needs, please contact Sexton, Bailey Attorneys, PA online or by calling us at (479) 443-0062.