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How Are IRA and 401 (k) Withdrawals Taxed?

How are IRA and 401(k) withdrawals taxed?

March 26, 2020 By Claudia Chang Leave a Comment

In a previous post, we defined withdrawals and distributions, and then we explored the differences between them.

Now that you have a better understanding of what they are, let’s dig into the question that gnaws at us all: how exactly are withdrawals and distributions taxed?

Part of the answer to this question involves looking at the differences between how the different types of retirement accounts are taxed, so that you can pick the one that best matches your retirement goals.

Withdrawal and Distribution Taxes

The Allure of Tax-free Growth on Retirement Savings

A key part of what makes both IRAs and 401(k) plans so attractive for those planning their retirement is the ability to enjoy tax-free growth on their savings.

IRAs were created as part of the Employee Retirement Income Security Act of 1974, and 401(k)s soon followed with the Revenue Act of 1978. 401(k)s are actually named after Section 401(k) of that Act, which granted employees a tax-free option to defer compensation from the stock options or other bonuses their companies gave them.

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At the time, the idea of tax-advantaged savings was entirely novel, and the details of these accounts still needed a few iterations before becoming the account types we recognize today. It was not until 1981 that employees were granted the option to directly place their salary into these retirement vehicles. Since that time, we’ve come a long way in developing more options for retirement savings, with a wide array of different IRA types available for the individual to choose from.

Both regular IRAs and 401(k)s generally offer deferred taxes on contributions, which means that you aren’t taxed on any income you direct into these accounts in the year you made it. Instead, you will be taxed upon withdrawals and distributions.

Avoid Capital Gains Taxes

Since you’re only paying taxes when you finally take your money out of your IRA or 401(k), you are safe from having to deal with capital gains taxes. If you were to invest in these outside of a retirement account, you would have to grapple with calculating your capital gains and losses.

Now, at the time of the withdrawal or distribution, the amount you take out of your retirement account will lose its tax-deferred status and be counted as ordinary income in that taxable year. In other words, your current income tax rate is applied to all withdrawals and distributions—with one exception.

When we said that IRAs and 401(k)s “generally” offer tax-deferred contributions, we were excluding the primary exception: Roth accounts. If you own or are considering a Roth IRA or Roth 401(k) plan, know that they work in the exact opposite way from what we described.

Roth Accounts: The Exception to the Rules

A Roth account only allows after-tax contributions—meaning, there is no tax deferral here because you pay taxes upfront when you contribute to your retirement account.

You can contribute the same amount to a Roth as to the corresponding Traditional type of account. So,  Roth IRA limits equal Traditional IRA limits, and Roth 401(k) limits equal Traditional 401(k) limits up to certain income thresholds.

However, the income used to contribute to a Roth version of either type must be taxed in the year it was made. This is an attractive option for some people who prefer to pay their taxes upfront and get them over with; they aren’t willing to bank on future tax rates.

When money is either withdrawn or distributed from a Roth account, it is generally tax-free. We say “generally” here because the rules for when that money is taken out do still apply—think back to those three life periods we mentioned in that previous post. If the account owner is under the age of 59 ½ and/or has had their account for less than five years, a withdrawal from a Roth account is going to be penalized; but as long as the withdrawal is made from contributions and not gains, there are no additional taxes due. Gains can be taxed on withdrawals from Roth accounts prior to the age of 59 ½.

Tax Deductions

For the most part, any income you use to contribute to either a non-Roth 401(k) or a non-Roth IRA is also tax-deductible in the year you make it. This means that besides not paying taxes on that income until withdrawal or distributions, you’ll also be able to use it to lower your current-year tax bill.

There is a critical caveat, however.

Both 401(k)s and IRAs put limits on how much can be contributed each year tax-free.

For 401(k)s, that tax-free contribution limit is $19,500 starting in the 2020 tax year (it was $19,000 for the 2019 tax year). For Traditional IRAs, the tax-free contribution limit is only $6,000 (or $7,000 if you are at least 50 years old), which is the same across the 2020 and 2019 tax years. Other types of IRAs, such as SEP IRAs and SIMPLE IRAs, have their own limits. Becoming familiar with these limits can help you decide which specific type of retirement account you’d like to contribute to.

There is another tax consideration to keep in mind when evaluating what you can deduct from your taxable income, and that has to do with contributing to multiple different types of accounts.

The good news is that if you have a retirement plan at work like a 401(k), you can have an IRA too. The potentially difficult news is that if you make more than a certain amount of money (a modified adjusted gross income of $65,000 if you’re single or $104,000 if you’re married), your IRA contributions may not be deductible.

You can find the exact income cutoffs as well as learn more about how partial contribution deductions work for this directly from the IRS.

 

Navigating taxes can get tricky; not only do you need to understand what the tax code says, but you need a strong grasp of how the individual components of your income and portfolio interact with each other in the eyes of the IRS. We’ve created a primer of sorts here on the taxation of withdrawals and distributions, and we hope it might help you start to figure out which types of retirement accounts will work best for you.

However, in no way is this a substitute for the advice of a certified tax professional, who can examine your particular situation and give you the most accurate, up-to-date information and recommendations.

 

 

Filed Under: IRA Investment, Retirement, Retirement 401k, Retirement Advice, Retirement Planning, Retirement Resources, Retirement Taxes, Roth IRA, SEP, SIMPLE, Traditional IRA

Claudia Chang

About Claudia Chang

This digital nomad is on a quest for financial independence. Having seen her parents struggle to make ends meet, Claudia is set on building the life she wants. She writes mainly on finance, particularly retirement and personal investing.

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