How Do I Know If My IRA is Taxable?
An individual retirement account (IRA) is an excellent way to save for the future, but it’s essential that you know if it is taxable.
Withdrawals made prior to age 59 1/2 are typically subject to an additional 10% penalty tax; however, there may be exceptions.
Contributions
Many investors use multiple IRA accounts to diversify their portfolio across a variety of investment types or institutions, such as financial services. Doing this allows you to avoid exceeding the one rollover per year limit or violating other rules such as not having enough income in one particular year to contribute. It’s also wise to consult a financial professional prior to making changes or additions to your portfolio.
Your IRA account statements can provide the data you need to determine if your IRA is taxable, such as with your 1099-R distribution report and Form 8606 which calculates withdrawals when your traditional IRA contains nondeductible contributions.
Calculating nondeductible contributions involves multiplying their numerator by the denominator containing all traditional IRA balances on that date (plus any previous years’ nondeductible contributions). You can find Form 8606 either with your tax return instructions or at IRS.gov.
Earnings
Retirement clients frequently inquire about the tax considerations of their IRA accounts. Schwab offers advice and information on a variety of topics related to these accounts, including contributions and withdrawal taxes as well as inheritance-related issues.
Typically, any growth in an IRA account is tax-deferred until it’s time to withdraw it in retirement. Withdrawals before age 59 1/2 usually incur both income taxes and an early withdrawal penalty tax; however, exceptions exist for medical expenses and first-time home purchases.
If you want to move IRA funds between accounts, it’s essential that you understand that only one rollover may occur per year and that waiting 60 days between attempts may be required before trying again. Furthermore, keep your beneficiaries up-to-date as their account basis may become subject to tax distribution rules (required minimum distributions are calculated based on life expectancy factors in IRS Publication 590-B); should you miss your RMD by more than 25 percent, additional penalties could apply as penalties will likely incur.
Withdrawals
If you withdraw money from an IRA, it’s generally taxed at your ordinary income rate based on your tax bracket and subject to an early withdrawal penalty of 10%, unless one of the exceptions apply.
Avoid this penalty by performing a direct rollover of an IRA distribution from one account to another within 60 days, including trustee-to-trustee transfers between IRAs or direct transfers from an IRA into a health savings account (HSA). Each year is limited to one such rollover transfer.
Other examples where withdrawals from an IRA are exempt from penalties include using funds to cover unreimbursed medical expenses or, in certain instances, unemployed health insurance coverage. You will need to file Form 5329 from the Internal Revenue Service with your tax return in these instances.
Rollovers
Transferring funds directly from a retirement plan into an IRA is generally tax-free, though you should exercise care as there may be exceptions to this rule.
The direct transfer rule only applies if your distribution from a former employer is made payable directly to an IRA custodial financial organization or sent electronically directly to it (and not you personally). These rules do not cover trustee-to-trustee transfers between IRAs or company retirement plans; nor rollovers of Roth IRA contributions.
Rule does not apply if funds are used to cover unreimbursed medical expenses, first-time home purchases or qualified higher education expenses. You are only allowed one direct rollover annually; any excess amounts are taxed at their normal rates (and included with an early withdrawal penalty of 10% for individuals under 59 1/2). For this reason, an indirect rollover might be the better choice in such instances.
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