IRA taxes: Key rules to know and how much you can expect to pay

The individual retirement account, or IRA, is one of the best retirement plans out there. An IRA is like a “wrapper” around a financial account that gives you special privileges, especially around the taxes that you have to pay.

Unfortunately, the rules around the IRA can be confusing and obscure. Even when they are clear, the rules are strict, and you could be penalized severely for a mistake, so be careful that you don’t run afoul of them.

Here’s how IRAs are taxed and how you can avoid paying any penalty taxes on your savings.

Taxes on traditional IRAs vs. Roth IRAs

IRAs come in two major varieties — the traditional IRA and the Roth IRA. The distinction is critical because each type offers various benefits and is taxed differently. (If you need a quick refresher, here’s everything you need to know about IRAs.)

The short story: A traditional IRA gets you a tax break today, but you pay taxes when you withdraw any money. Meanwhile, a Roth IRA allows you to take tax-free distributions in the future in exchange for contributing after-tax money today.

Here’s a quick breakdown of the key differences in how these two IRA types are taxed:

When do you pay taxes on IRA withdrawals?

Traditional and Roth IRAs treat withdrawals very differently. In a nutshell:

• Qualified withdrawals from a traditional IRA in retirement (typically after age 59 ½) are taxable.
• You can withdraw money you contribute to a Roth IRA without being taxed at any time, even before retirement. And once you’re age 59 ½, all Roth IRA withdrawals (both contributions and earnings) are completely tax-free.

Here’s more about why the IRS taxes traditional IRA withdrawals and not Roth IRA withdrawals.

As shown in the table, traditional IRA accounts allow you to contribute with pre-tax income, so you don’t pay income tax on the money that you put in. Earnings on the account are tax-deferred, so any dividends and capital gains there can pile up while they’re inside the IRA.

However, eventually the IRS wants its cut. When it’s time to make a retirement withdrawal — after age 59 ½ — you’ll pay tax on the gains as if they were ordinary income. If you take a distribution before that age, you’ll typically owe an early withdrawal penalty, which is covered below.

The tax break for traditional IRAs can be significant, but it can be limited by your income and whether you’re covered by a workplace retirement plan. The IRS has further details, but the upshot is that if your income is too high, you won’t be able to make a pre-tax contribution. However, you can still make an after-tax, or non-deductible, contribution to a traditional IRA.

In contrast, contributions to a Roth IRA account are made with after-tax income. Like a traditional IRA, the Roth allows you to defer tax on any dividends and capital gains in the account. Because you already paid taxes on the money before you put it into the account, your business with the IRS is done. When you take a qualified distribution, it’s tax-free. While there are technically income restrictions on contributing to a Roth IRA, you can legally get around them by opening a backdoor Roth IRA.

How much tax will you pay on IRA withdrawals?

For Roth IRAs, you can take out any contributions to the account at any time and owe $0 in taxes. And if you have any earnings on the money, it’s simple to figure out how much tax you’ll pay on qualified distributions (e.g., distributions after age 59 ½): also zero. That sounds suspiciously easy, but that’s part of the Roth’s appeal.

There’s one major stipulation on the Roth’s tax-free policy. It’s called the five-year rule, and it says that you can take the earnings out tax-free only if five years have elapsed since the tax year of your first Roth contribution. It’s not onerous, but it’s key to know about the five-year rule. Then when you’re retired — defined as older than 59 ½ — your distributions are tax-free. They are also tax-free if you’re disabled or in certain circumstances like if you’re buying your first home.

In contrast, for a traditional IRA, you’ll typically pay tax on withdrawals as if they were ordinary income. For example, if you’re in the 20 percent marginal tax bracket, you’d owe 20 percent of the amount of the withdrawal, which translates into $2,000 in taxes on a $10,000 withdrawal from a traditional IRA, a $5,000 tax bill on a $25,000 distribution and $10,000 to the IRS if you take out $50,000. 

However, for traditional IRAs, the taxable amount also depends on whether you were able to contribute with pre-tax money or not. If you weren’t able to take a tax break for the contribution, then you’re contributing after-tax money to the IRA. Therefore, the IRS doesn’t charge you on this nondeductible portion of a withdrawal, though you’ll still owe taxes on any earnings.

What if you withdraw money early from an IRA?

You can take money out of your IRA at any time, but that doesn’t mean the IRS won’t ding you for it. Stiff tax penalties for early withdrawals are one of the downsides of contributing to an IRA, but they’re not the same for traditional IRAs and Roth IRAs. 

The Roth IRA tends to be more flexible. As noted above, the IRS allows you to withdraw contributions to the Roth IRA without penalty at any time. Any non-qualified withdrawals such as earnings that exceed your contributions, though, are subject to a penalty tax.

For the Roth IRA, if you take a distribution that isn’t qualified, you may be subject to a 10 percent bonus penalty on the withdrawal, but there are exceptions. These exceptions include being disabled, using the money to buy a first home, facing high medical expenses and other specific scenarios.

Generally, for a traditional IRA, if you’re taking a distribution before age 59 ½, you’ll have to pay an additional 10 percent penalty on the withdrawal. That’s on top of the taxes on the withdrawal itself if you made a tax-deductible contribution. 

Here’s how an early withdrawal from a traditional IRA would play out for someone who who is not yet 59 ½ and whose income is taxed at 20 percent: On a $10,000 early withdrawal, they’d owe $3,000 — $2,000 in income taxes and $1,000 for the 10 percent early withdrawal penalty. A $25,000 withdrawal would be whittled down to just $17,500 once they settle up with the IRS.

The impact of that extra 10 percent penalty should make you think twice about raiding your retirement accounts early. That said, there are circumstances in which the IRS waives the penalty: if you’re disabled, have high medical bills, are buying a first home and several other defined scenarios.

And if you’ve made non-deductible contributions to the traditional IRA — contributions that were made after tax — then you’ll be able to withdraw this portion without a bonus penalty. However, you’ll still owe taxes on any earnings on the amount that you withdraw.

What is the required minimum distribution penalty?

Taxes also come into play if you fail to withdraw a minimum amount of money — known as a required minimum distribution (RMD) — from an IRA each year when you reach a specific age. You don’t have to worry about RMDs if you own a Roth. But if you have a traditional IRA (your own or inherited) or inherit a Roth IRA, you’ll want to follow IRS RMD rules to the letter.

The penalty for failing to take RMDs or not withdrawing enough is stiff: Any money not withdrawn by the deadline will be taxed at 25 percent.

For example, if you were required to withdraw $18,000 from your IRA and only took out $15,000, you’d owe $750 in penalty taxes (25 percent of the $3,000 you failed to withdraw). Correcting the mistake (see Form 5329) in a timely matter or having a compelling reason for missing the deadline can lower the penalty to 10 percent or get it waived altogether. RMDs kick in at age 73 and continue every year thereafter. (Note: The RMD age is scheduled to gradually increase to age 75 by 2033.) You have until April 1 of the year following the year you turn 73 to take your first full RMD. After that, you’ll generally have until Dec. 31 of the current year to comply. (See our RMD explainer for more on how the IRS calculates RMDs and how to run the math for yourself.) 

Which type of IRA is better?

The type of IRA that’s better often depends on your own financial circumstances. For example, if you’re currently in a higher tax bracket, it might make sense to go with a traditional IRA in order to get an immediate tax break.

In contrast, if you’re in a lower tax bracket, it might make more sense to go with the Roth IRA. The reasoning: You don’t currently pay a lot in taxes, but in the future when you begin withdrawals in retirement and are in a higher bracket, you’ll avoid a bigger tax hit from Uncle Sam thanks to the tax-free withdrawals offered by a Roth. 

To simplify this distinction further, financial advisors often ask their clients whether they expect to be in a higher or lower tax bracket in the future than they are now. If clients expect to be in a lower bracket, it might be better to go with a traditional IRA. If higher, then the Roth may make more sense. In other words, the decision is really a question of paying the lower tax rate and estimating whether the lower rate is likely to occur now or later.

While this tax consideration is one of the most important factors in deciding between a Roth and a traditional IRA, it’s not the only one. The Roth presents other benefits in planning your estate, for example, and the peace of mind in knowing that you’ll never have to pay taxes again on your IRA withdrawals is worth a lot to some investors, maybe even more than the tax savings today.

Bottom line

The IRA can be an incredible tool for planning a great retirement, but you’ll need to understand the tax implications of your choice in order to get the most out of the program. Each year, you have until Tax Day, usually April 15, to deposit your contributions for the prior year. It’s easy to get started, and with top online brokers, like Fidelity and Charles Schwab, you can open an account in minutes.

— Bankrate’s Dayana Yochim contributed to an update of this article.