How IRA Distributions Are Taxed in Retirement

​According to a recent study, Americans hold nearly $2.5 trillion in individual retirement accounts (IRAs), making the IRA one of the most commonly used retirement savings vehicles. Those nearing retirement, between the ages of 60 and 64, have an average of $165,139 in their IRA.1 If you’re like most Americans, your IRA will be a significant income source in retirement.
 
IRAs are popular vehicles largely because of their favorable tax treatment. In traditional IRAs and other types, such as the SEP and SIMPLE, you can deduct your contributions. All IRAs also offer tax-deferred growth. That means you don’t pay taxes on your gains as long as the funds stay inside the account.

While IRAs may offer a tax-favored method for accumulating retirement assets, they can also generate tax exposure in retirement. It’s important to understand how your IRA distributions could be taxed so you can plan accordingly. Below are a few important guidelines to keep in mind:

Traditional IRA
Most IRA assets are held in traditional IRAs. These IRAs allow you to deduct your contributions from your taxes, assuming you meet income limitations. You can allocate your contributions to a wide range of investment options based on your specific goals and needs. The funds then grow on a tax-deferred basis inside the account.
 
Traditional IRAs provide an upfront tax benefit, but they can generate tax liability in retirement. Your distributions are taxed as income. That means all withdrawals from a traditional IRA are considered taxable. If your traditional IRA will provide a significant portion of your income in retirement, you could have a sizable tax liability.
 
Remember, you don’t face any taxes until you take a distribution. However, you can’t delay your distributions forever. Traditional IRAs have something called required minimum distributions (RMDs), which start at age 70½. At that time, you’re required to withdraw a minimum amount. Those withdrawals continue for the rest of your life, and the amount could increase as you get older.

Roth IRA
The Roth IRA was introduced almost 20 years ago, and it has gained popularity in recent years. Like a traditional IRA, the Roth offers tax-deferred growth as long as your funds are inside the account.
 
However, contributions and withdrawals are treated differently in a Roth. Your contributions are not tax-deductible, which means they’re made with after-tax dollars. However, all your withdrawals from your Roth are tax-free, assuming you are over age 59½ and the account has been open at least five years.
 
Roth IRAs also don’t have RMDs. That means you can keep your funds in the account as long as you want. In fact, you never have to take a distribution if you don’t want to, and the balance is passed tax-free to your beneficiaries.

Early Distribution Penalty
All IRAs have something called an early distribution penalty. Remember, IRAs are meant to be retirement savings vehicles. That means you’re not supposed to take money out of the accounts unless you are retired.
 
For penalty purposes, the IRS considers 59½ to be retirement age. If you are 59½ or older, you can take IRA distributions without facing a penalty. If you are younger than that age, however, you could face a 10 percent penalty on your distribution. There are some exceptions for things like medical issues and disability. However, you should expect to pay a penalty if you want to take an early withdrawal.
 
Ready to plan your IRA distribution strategy? Let’s talk about it. Contact us today at DSM Financial. We can help you analyze your needs and develop a strategy. Let’s connect soon and start the conversation.

 
1https://www.fool.com/retirement/2016/06/27/heres-how-much-the-average-american-has-in-an-ira.aspx
 
 
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