When you take withdrawals from your traditional IRA, you probably understand they’re taxable. But what does that really mean? Here’s what you need to know about how traditional IRA withdrawals are taxed, when part of a withdrawal may be tax-free, and what reporting rules apply.
Important: In the context of this article, “withdrawals” means garden-variety payouts from IRAs set up in your name, as opposed to required minimum distributions (RMDs), which are a separate topic. Contact your tax advisor for more information.
To determine the federal income tax consequences of a withdrawal, first figure out how many traditional IRAs you have. Remember to include:
If you have several traditional IRAs, you must add them together and treat them as one account to determine the tax consequences of taking withdrawals from any of them. However, if your spouse owns an IRA, it doesn’t affect how withdrawals from your IRAs are taxed. The tax rules are applied separately to your accounts and your spouse’s accounts.
If you take any IRA withdrawals this year, you’ll receive a Form 1099-R from your IRA trustee or custodian after year end. If you don’t report the withdrawal, you’ll likely hear from the IRS, because a copy of Form 1099-R is also sent to the agency.
When calculating how much of your withdrawal will be subject to federal income tax, there are two scenarios if you have only one IRA:
If you haven’t made any nondeductible contributions, all withdrawals are 100% taxable, and you must include them in your taxable income for the year you take them. If you take any withdrawals before age 59½, they’ll generally be hit with a 10% penalty tax unless an exception applies.
If you’ve made some nondeductible contributions over the years, those amounts create tax basis in your account, and each withdrawal from your traditional IRA will include some amount of basis. That amount is tax-free; the remainder is taxable.
To calculate the tax-free basis amount and taxable amount, create a fraction. The numerator equals your cumulative nondeductible contributions as of the end of the year. The denominator equals your IRA balance on that date plus all withdrawals taken during the year. Then multiply your withdrawals by that fraction. The result is the amount of tax-free withdrawals of basis. The rest of your withdrawals are taxable.
For example, suppose that as of December 31, you’ve made $12,000 in nondeductible contributions to your traditional IRA. During the year, you withdraw $20,000. On December 31, the account is worth $60,000.
The numerator of your fraction is $12,000. The denominator is $80,000 ($60,000 + $20,000). So, the tax-free basis portion of your distribution is $3,000 [($12,000 / $80,000) × $20,000]. The remaining $17,000 is taxable. If you’re under age 59½, you may also owe the 10% early withdrawal penalty tax.
The calculations become a little more complicated if you have more than one IRA. Again, there are two possible tax scenarios:
If you haven’t made any nondeductible contributions, all withdrawals are 100% taxable, regardless of how many IRAs you have. You must include the withdrawals in your taxable income for the year you take them. If you take withdrawals before age 59½, they’ll generally be hit with a 10% early withdrawal penalty tax unless an exception applies.
In this situation, you must create a fraction to calculate tax-free basis amounts and taxable amounts. The numerator equals your cumulative nondeductible contributions to all your IRAs as of the end of the year. The denominator equals the combined balances of all your IRAs on that date plus all withdrawals taken during the year. Then multiply your withdrawals by that fraction. The result is the amount of tax-free withdrawals of basis. The rest of your withdrawals are taxable.
For example, suppose that as of December 31, you’ve made $18,000 in nondeductible contributions to two traditional IRAs. You also have a rollover IRA funded with a distribution from a former employer’s 401(k). During the year, you withdraw $28,000. It doesn’t matter which account or accounts the money came from. On December 31, the three accounts are worth $272,000 combined.
The numerator of your fraction is $18,000. The denominator is $300,000 ($272,000 + $28,000). So, the tax-free basis portion of your withdrawal is $1,680 [($18,000 / $300,000) × $28,000]. The remaining $26,320 is taxable. If you’re under age 59½, you may also owe the 10% early withdrawal penalty tax.
Shortly after the end of each year that you take withdrawals from a traditional IRA, you should receive Form 1099-R from the IRA trustee or custodian. It will show the total amount of withdrawals for the preceding year. That is the amount you must report on your Form 1040 for that year. The taxable portion must also be reported on your return.
If you’ve made any nondeductible contributions, the calculations of tax-free and taxable amounts are generally handled on IRS Form 8606, which should be included with your return. Form 8606 also needs to be completed for any year you make nondeductible traditional IRA contributions, whether or not you take withdrawals that year. Reviewing prior-year Forms 8606 can help you determine your cumulative nondeductible contributions, which is critical to avoiding tax on amounts that should be treated as tax-free basis.
If you owe the 10% early withdrawal penalty tax, a separate IRS form may also be required and the penalty amount must be reported as additional tax due.
As you can see, the tax rules get complicated if you’ve made nondeductible contributions. Traditional IRA withdrawal tax treatment depends on whether contributions were deductible, how much basis you’ve built up, how many IRAs you own, and whether an early withdrawal penalty applies. Fortunately, you don’t have to sort through all of the required tax forms on your own. Contact your tax advisor to understand how withdrawals from your traditional IRA will affect your tax situation and how to report them correctly.
In general, the taxable portion of a withdrawal from a traditional IRA before age 59½ is subject to a 10% early withdrawal penalty tax on top of the regular income tax hit. But there are several exceptions to the penalty tax. Common examples include:
Your tax advisor can tell you if you’re eligible for these or any other exceptions to the 10% early withdrawal penalty tax.
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