How Do I Know If My IRA is Taxable?
Traditional IRA withdrawals are generally taxed as ordinary income; your tax advisor can explain any applicable exceptions or special rules that might apply.
To determine whether your IRA is tax-exempt, calculate both numerator and denominator of nondeductible contributions; divide your total IRA balance by this ratio; then multiply this figure to find your tax-free withdrawal amount.
Contributions
Traditional IRA contributions may be eligible for tax deductibility up to the limit based on your income and whether or not your employer provides access to an employee retirement plan. Be sure to speak to your IRA custodian regarding contribution limits for this year – generally until April 15 is reached, you have time to deposit them with them for this year’s contribution deadlines.
To ascertain whether you made nondeductible contributions, review previous returns and your custodian’s Form 5498 from the year in which the transaction took place. This form contains details about any nondeductible contributions as well as your IRA’s tax-free basis amounts; these figures are calculated as an ratio between your ending balance plus withdrawals and this figure.
By designating a public charity as your IRA beneficiary, you may also reduce future taxes. Your heirs pay their own income tax rate when withdrawing assets from their own IRAs and this strategy could save them money when withdrawing them themselves.
Withdrawals
Traditional and Roth IRA withdrawals may be taxed as ordinary income; Roth IRA withdrawals do not. Some withdrawals, however, are penalty-free: for instance if withdrawing money to cover unreimbursed medical expenses or needing funds during unemployment; this withdrawal does not incur a penalty fee. Also military personnel can make multiple withdrawals without penalty under certain conditions.
Your IRA custodian should send you a Form 1099-R each year that details what withdrawals were made, detailing any tax implications of withdrawing funds. If you have questions regarding these withdrawals and their tax ramifications, speak with an enrolled agent or professional for advice. If you don’t have your tax records handy, order transcripts from the IRS free of charge, or copies of past tax returns at $50 each – this process can be done at any time!
Required minimum distributions
As soon as IRA owners or participants in qualified employer sponsored retirement plans such as 401(k)s or 403(b)s reach certain age limits, they must begin taking required minimum distributions – otherwise an expensive penalty tax could ensue.
RMDs are calculated using a fraction that considers both tax-free basis amounts and taxable withdrawals, with the numerator representing your cumulative nondeductible contributions over your life and the denominator being all your IRA balances at the end of last year.
The IRS provides a worksheet to assist in calculating your RMD for any given year. This worksheet works in tandem with one of three life expectancy tables available through IRS Publication 590: uniform lifetime table, joint life and survivor expectation table or single-life expectation table (where applicable). If your spouse is more than 10 years younger than you, joint life and last survivor expectation table would be most appropriate.
Taxes
There are various circumstances that could deem an IRA withdrawal taxable, and its rules can be complex. One such instance would be when required minimum distribution (RMD) rules require you to start taking RMDs from traditional IRAs once you reach age 70 1/2 unless certain exceptions apply.
These exceptions include making substantially equal payments over your life expectancy or jointly with your beneficiary if married, as well as distributions for first-time home buyers. Even if an exception applies, however, income tax must still be withheld from withdrawals made under any circumstance.
Help your clients avoid unnecessary taxes by encouraging them to maintain accurate records. For instance, if they haven’t received Form 5498 for their IRA contributions yet, tax software can reconstruct these records on their behalf – saving thousands in taxes each year and possibly helping avoid an early withdrawal penalty of 10% – which can be significant.
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