Although Social Security should provide a portion of your retirement income, Social Security benefits alone will not guarantee a comfortable living for most individuals after retirement. So, obviously, retirement planning is critical if you want to enjoy your golden years. An IRA is one type of investment tool that can be used for retirement planning. However, most clients ask specifically how IRA withdrawals get taxed during retirement.
Individual Retirement Accounts and how they work
An Individual Retirement Account, or IRA, is one type of retirement investment account that comes with several tax advantages. With IRAs, you are not required to pay taxes on your earnings from the account. Instead, your earnings are reinvested and compounded so that your account can continue to grow. Once you have reached retirement age, you can start making withdrawals from your IRA. You will then be required to pay taxes depending on the type of IRA you have, the amount of your income and the amount if IRA funds you choose to withdraw.
Taxation of traditional IRAs
When making contributions to a traditional IRA, you are not required to pay taxes on those contributions. You are not required to pay taxes on the interest your account earns, either, until you start receiving withdrawals during retirement. This means that, a traditional IRA is funded with “pre-tax” dollars, and when you start withdrawing funds, those withdrawals are taxed as ordinary income. For instance, 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.
Taxation of Roth IRAs
Roth IRAs are taxed differently because they are funded with “after-tax” dollars. In other words, there are no tax benefits for contributions. Instead, the earnings and withdrawals are essentially free. With a Roth IRA, you are able to avoid taxes when you make withdrawals, but with traditional IRAs, you avoid taxes when making your contributions.
Early withdrawal 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. On the other hand, you are allowed to withdraw your initial contributions at any time with a Roth IRA, without paying a penalty. That is because you have already paid income taxes on that money.
Converting your account to a Roth IRA
If you have a traditional IRA, or employer-sponsored retirement plan, you have the option of converting either of those accounts to a Roth IRA. It is simple to make the conversion. All you need to do is transfer some or all of your existing retirement account balance to your new Roth IRA, regardless of your current income. Converting a traditional IRA to a Roth IRA can be a clever option, particularly if you expect your tax rate to increase in the near future. 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 IRA withdrawals, or any other retirement planning needs, please contact the Schomer Law Group either online or by calling us at (310) 337-7696.