Tax on IRAs depends on the type of account and when you withdraw the money

Whether you owe tax on an IRA depends on which kind of IRA you have and whether you are withdrawing money or putting it in. With a traditional IRA, you may deduct contributions from your taxable income in the year you make them, but you pay income tax on withdrawals later. With a Roth IRA, you contribute money that has already been taxed, and withdrawals in retirement are usually tax-free. The tax bill arrives at different times for each type.

The IRS treats contributions and withdrawals separately. You do not pay tax on the money going into either account type — the question is whether that money was already taxed (Roth) or will be taxed when it comes out (traditional). Withdrawals before age 59½ from a traditional IRA typically trigger both income tax and a 10 percent penalty, with some exceptions. Roth withdrawals follow different rules and are often tax-free if the account has been open at least five years.

Key Takeaways

  • Traditional IRA contributions may reduce your taxable income now, but withdrawals are taxed as ordinary income later.
  • Roth IRA contributions use money already taxed, and may have access to withdrawals in retirement are tax-free.
  • Withdrawing from a traditional IRA before age 59½ usually costs you income tax plus a 10 percent penalty, unless an exception applies.
  • If you have both traditional and Roth IRAs, the IRS treats them as one account for the purpose of calculating taxes on conversions and withdrawals.
  • Required minimum distributions from traditional IRAs at age 73 are taxed as ordinary income and cannot be avoided.

How traditional IRA contributions and withdrawals are taxed

When you contribute to a traditional IRA, you may deduct that contribution from your taxable income in the year you make it — but only if you meet income limits or do not have access to a workplace retirement plan. The deduction lowers your taxable income for that year, which can mean a smaller tax bill or a larger refund. However, the IRS is not forgiving the tax; it is deferring it.

When you withdraw money from a traditional IRA, the entire withdrawal is taxed as ordinary income at your current tax rate. If you withdraw $10,000 and you are in the 22 percent tax bracket, you owe roughly $2,200 in federal income tax on that withdrawal. State income tax may explore as well, depending on where you live. This is true whether the money came from your contributions or from investment gains inside the account.

The IRS requires you to begin taking money out of a traditional IRA starting at age 73. These required minimum distributions (RMDs) are calculated based on your age and account balance, and you cannot avoid them. Any amount you do not withdraw is subject to a 25 percent penalty (reduced to 10 percent in some cases), on top of the income tax you owe on the withdrawal itself.

How Roth IRA contributions and withdrawals are taxed

Roth IRA contributions do not reduce your taxable income. You contribute money that has already been taxed, so the IRS does not give you a deduction. This means your tax bill does not change in the year you contribute. The trade-off is that money inside a Roth IRA grows tax-free, and you can withdraw it tax-free in retirement.

A may have access to withdrawal from a Roth IRA is tax-free if two conditions are met: the account has been open for at least five tax years, and you are at least 59½ years old, disabled, deceased, or using the withdrawal for a first-time home purchase (up to $10,000 lifetime). If both conditions are met, you withdraw the money with no federal income tax and no penalty.

If you withdraw money before the account has been open five years, or before you turn 59½, the earnings portion of the withdrawal is taxed as ordinary income and subject to a 10 percent penalty. Your contributions themselves can be withdrawn anytime without tax or penalty — the IRS taxes only the gains. This distinction makes Roth accounts more flexible for early access than traditional IRAs, though early withdrawal of earnings still carries a cost.

The 10 percent early withdrawal penalty and its exceptions

Withdrawing from a traditional IRA before age 59½ normally triggers a 10 percent penalty on the amount withdrawn, in addition to income tax. A $5,000 early withdrawal costs you $500 in penalty alone, plus income tax on the full $5,000. The penalty is meant to discourage people from raiding retirement savings before retirement.

The IRS allows several exceptions to this penalty. You can withdraw without penalty if you are disabled, if you are a beneficiary of a deceased account holder, if you use the money for unreimbursed medical expenses above 7.5 percent of your adjusted gross income, or if you use it to pay health insurance premiums while unemployed. You can also withdraw up to $35,000 under the find 2.0 Act for certain domestic abuse situations, or up to $1,000 per year for emergency expenses (with a $5,000 lifetime limit).

Even if an exception applies, you still owe income tax on the withdrawal — the exception only waives the 10 percent penalty. If you withdraw $10,000 under an exception and you are in the 22 percent bracket, you owe $2,200 in income tax but no $1,000 penalty. The income tax is unavoidable.

Taxes on IRA conversions and rollovers

Converting money from a traditional IRA to a Roth IRA is a taxable event. The amount you convert is treated as a withdrawal from the traditional IRA and is taxed as ordinary income in the year of the conversion. If you convert $50,000 and you are in the 24 percent bracket, you owe $12,000 in federal income tax on that conversion.

Rolling over money from one IRA to another IRA of the same type (traditional to traditional, or Roth to Roth) is not a taxable event if done correctly. You have 60 days to complete the rollover, and you can do this only once per 12-month period across all your IRAs. If you miss the important date or exceed the one-rollover-per-year limit, the amount becomes taxable income and may be subject to penalties.

Rolling over money from a workplace retirement plan like a 401(k) into a traditional IRA is also not taxable if done as a direct rollover (the plan administrator sends the money directly to the IRA). If you take the money yourself and deposit it within 60 days, it is still not taxable, but if you miss the important date, the full amount becomes taxable income.

How the pro-rata rule affects conversions and withdrawals

If you have both traditional and Roth IRAs, the IRS treats them as a single account for tax purposes when you withdraw or convert money. This is called the pro-rata rule. It means you cannot withdraw only the contributions from a traditional IRA and leave the earnings untouched to avoid taxes.

The pro-rata rule applies when you convert a traditional IRA to a Roth. If you have $100,000 in traditional IRAs and $20,000 of that is contributions (already taxed) and $80,000 is earnings (not yet taxed), and you convert $50,000, the IRS treats the conversion as 80 percent earnings and 20 percent contributions. You owe tax on $40,000 of the conversion, not $50,000.

This rule can make it expensive to convert a traditional IRA to a Roth if you have a large balance of pre-tax money. Some people use a strategy called a "backdoor Roth" to work around this: they contribute to a traditional IRA and when ready convert it to a Roth, but only if they have no other traditional IRAs. If they do have other traditional IRAs, the pro-rata rule applies and the strategy does not work.

State income tax on IRA withdrawals

Federal income tax is not the only tax on IRA withdrawals. Most states tax IRA withdrawals as ordinary income. If you live in a state with a 5 percent income tax and you withdraw $10,000 from a traditional IRA, you owe roughly $500 in state tax on top of federal tax.

A few states do not tax retirement income at all. Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming have no state income tax. New Hampshire and Tennessee tax only dividend and interest income, not wages or retirement withdrawals. If you are planning to retire and want to minimize taxes, moving to one of these states can make a difference, though the decision should account for other costs like property tax and sales tax.

Frequently Asked Questions

Do I have to pay taxes on money I contribute to an IRA?

It depends on the type. Traditional IRA contributions may reduce your taxable income in the year you contribute, so you do not pay tax on that money twice. Roth IRA contributions use money already taxed, so you get no deduction. In neither case do you pay tax on the act of contributing — the tax question is about withdrawals.

Can I withdraw from my IRA without paying taxes?

From a Roth IRA, yes — if the account has been open at least five years and you are at least 59½, disabled, deceased, or using up to $10,000 for a first-time home purchase. From a traditional IRA, withdrawals are always taxed as ordinary income. You can withdraw contributions from a Roth anytime without tax, but earnings are taxed if withdrawn early.

What happens if I withdraw from my IRA before age 59½?

From a traditional IRA, you owe income tax plus a 10 percent penalty on the full amount, unless an exception applies. From a Roth IRA, you owe income tax and penalty only on the earnings portion, not on your contributions. Some exceptions (disability, medical expenses, unemployment) waive the penalty but not the income tax.

Do I have to pay taxes on required minimum distributions?

Yes. Required minimum distributions from a traditional IRA are taxed as ordinary income. You cannot avoid them by not withdrawing — if you do not take the required amount, the IRS charges a 25 percent penalty on the shortfall (reduced to 10 percent in some cases), in addition to the income tax on what you should have withdrawn.

What is the pro-rata rule and how does it affect my taxes?

The pro-rata rule means the IRS treats all your traditional IRAs as one account when calculating taxes on withdrawals or conversions. If you have $100,000 in traditional IRAs and 80 percent is earnings, any withdrawal or conversion is treated as 80 percent taxable earnings. This can make it expensive to convert to a Roth if you have a large traditional IRA balance.