Individual retirement accounts (IRAs) are one of the most important account types, and understanding the difference between Roth and traditional contributions and withdrawals is foundational to tax planning. While these rules seem simple, there are more complexities than appear at first glance. This article will detail the minute differences between various IRA contributions and withdrawals.
Each IRA contribution is implemented identically with your custodian. To contribute, taxpayers journal cash from a regular brokerage account to the chosen IRA. Then, the titling of the IRA and how you file your taxes determine the final contribution type.
While there are only two types of IRAs, there are three types of IRA contributions.
The first is a deductible traditional IRA contribution. This contribution is pre-tax and is eligible for a tax deduction that reduces the taxpayer’s AGI. To complete the contribution, cash is moved to a traditional IRA, and the taxpayer claims a corresponding IRA deduction on Schedule 1 of the 1040 (currently line 20).
The second is a nondeductible traditional IRA contribution. This contribution is post-tax and receives no tax deduction even though it is contributed to a traditional IRA. To complete the contribution, cash is moved to a traditional IRA, and the taxpayer files a Form 8606 to report and track their nondeductible contributions.
The third is a Roth IRA contribution. This contribution is post-tax and receives no tax deduction. To complete the contribution, cash is moved to a Roth IRA. While there is no additional tax return reporting required, it is wise to keep track of your Roth contributions alongside your tax return to aid in future tax reporting.
Which IRA contribution type you make will determine how or if those retirement funds are taxed when you distribute.
From a traditional IRA, there are two sources of withdrawals:
- Withdrawal of nondeductible basis (sometimes also called an after-tax basis)
- Regular withdrawal
If a taxpayer has both deductible and nondeductible basis attributable to their name, then they are required to calculate which part of each distribution is a regular distribution (pre-tax) and which part is nondeductible (post-tax). This is done by aggregating the tax year’s distributions and end of year balances as though all of your IRAs are mixed together and then prorating the nondeductible basis as though it were attributable to each section.
The analogy is: Like you can’t take a sip of your coffee without getting part coffee and part cream, so too you can’t withdraw from your IRA assets without getting part traditional and part nondeductible.
Regardless of age or reason, the nondeductible portion of a withdrawal is always free of tax and penalty.
The regular distribution portion is usually taxable at ordinary income rates, but a qualified charitable distribution (QCD) is a noteworthy exception.
There are three types of withdrawals from a traditional IRA:
- Early distribution
- Normal distribution
- Qualified charitable distribution (QCD)
After age 70 ½, an IRA owner can make a qualified charitable distribution (QCD) if the IRA owner distributes from the traditional IRA directly to a qualified charity. This type of distribution is limited as up to $100,000 per year. Even though these funds are sourced from a traditional IRA, QCDs are excluded from taxation. They are also excluded from penalty, both because they are not taxable and also because tax payers who are older than age 70 ½ are also older than age 59 ½, meeting an exception to the early withdrawal penalty.
Qualified charitable distributions are always exclusively sourced from your regular IRA balance. No portion of a QCD is from nondeductible basis.
On the other hand, both early distributions and normal distributions are prorated to calculate how much is nondeductible. As mentioned before, the nondeductible portion of a withdrawal is always free of tax and penalty.
Distributions from traditional IRAs taken prior to age 59 ½ are early distributions. Early distributions are subject to the 10% early distribution penalty unless they meet an exception (discussed below).
Both early distributions and normal distributions are taxable as ordinary income.
In a Roth IRA, there are two types of withdrawals:
- Qualified withdrawal
- Non-qualified withdrawal
If a withdrawal from a Roth IRA is qualified, it is free of tax and penalty. For a withdrawal to be qualified, a taxpayer needs to meet two requirements.
First, the taxpayer must have contributed to a Roth IRA more than 5 tax years ago.
Second, the distribution needs to meet one of these requirements:
- made after the taxpayer is age 59 ½
- the taxpayer is disabled
- the taxpayer is dead
- the taxpayer’s distribution meets the First Home exception
Generally, taxpayers meet this requirement by being older than age 59 ½.
A non-qualified withdrawal is one that doesn’t meet the criteria to be qualified. The tax or penalty imposed on a non-qualified withdrawal depends on the source of the withdrawal and whether the taxpayer meets specific exceptions.
From a Roth IRA, there are three sources of withdrawals:
- Withdrawal of regular contributions, called contribution basis
- Withdrawal of Roth conversion basis, called rollover contribution basis
- Withdrawal of earnings
At all times and at any age, a taxpayer can withdraw their regular contributions free of tax and free of penalty.
Roth Conversion Basis
Withdrawals from Roth conversion basis are always free of tax. However, non-qualified withdrawals from this source may be subject to a 10% recapture penalty.
The recapture penalty is designed to prevent taxpayers from avoiding an early withdrawal penalty from their traditional IRA.
A traditional IRA withdrawal before age 59 ½ could face a 10% early withdrawal penalty. If the recapture penalty did not exist, then taxpayers could do a Roth conversion and then immediately withdraw the same amount from the Roth IRA to avoid the early withdrawal penalty. The recapture penalty makes it so that taxpayers cannot use such a simple loophole to avoid the penalty. Instead, the IRS says that you still have the 10% penalty when you withdraw from your rollover contribution basis if it has been less than five years since you converted.
Each Roth conversion has its own timeline. The day that you convert traditional IRA assets to Roth IRA starts a 5-year clock for those particular assets.
The earnings portion of a Roth IRA is anything that cannot be attributed to either kind of contribution basis.
The IRS assumes that you withdraw from regular contribution basis first, from rollover contribution basis second, and lastly from earnings. This means you can only have a taxable withdrawal after both of your contribution basis types are used up.
If the withdrawal is non-qualified, the earnings portion of the Roth withdrawal is taxed as ordinary income. It may also be subject to a 10% early distribution penalty.
Qualified vs. Non-qualified Summary
The rules that determine if a withdrawal is qualified can be complex. However, remember that if you are over age 59½ and your Roth IRA was first funded more than 5 years ago, all your withdrawals are qualified withdrawals. Once you have determined that a withdrawal is qualified, no additional analysis is needed to determine that it is free of tax and penalty.
Exceptions to Early Withdrawal / Recapture Penalty
In addition to normal taxation, IRA distributions before age 59½ may be subject to a tax penalty. Early distributions from a traditional IRA, non-qualified distributions from recaptured Roth conversion basis, and non-qualified distributions from earnings in a Roth IRA are subject to a 10% early withdrawal penalty if one of the following exceptions is not met.
The exceptions to the early withdrawal penalty are:
- You have reached age 59½.
- You are totally and permanently disabled.
- You are the beneficiary of a deceased IRA owner.
- You use the distribution to buy, build, or rebuild a first home.
- The distributions are part of a series of substantially equal payments.
- You have unreimbursed medical expenses that are more than 10% (or 7.5% if you or your spouse was born before January 2, 1952) of your adjusted gross income (defined earlier) for the year.
- You are paying medical insurance premiums during a period of unemployment.
- The distributions are not more than your qualified higher education expenses.
- The distribution is due to an IRS levy of the qualified plan.
- The distribution is a qualified reservist distribution.
IRAs are essential for meeting retirement goals in a tax efficient manner. Mastering the complexities of these account types will help you to maximize their benefit in your specific situation.
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