Federal Income Tax Rules Regarding IRA Holdings

The federal income tax rules regarding IRA holdings differ depending on the type of IRA you open and whether your contributions were tax deductible. In general, tax deductible IRA contributions are subject to income tax at the time of withdrawal, while IRA contributions that were made with after-tax money -- such as Roth IRA contributions -- are not.

Traditional IRAs

Contributions you make to a traditional IRA may be tax deductible in the year you make them, depending on your employment benefits and annual income. If you don't have access to a retirement plan through an employer, your traditional IRA contributions are fully deductible unless you are married and your spouse is covered by a work-offered plan. In this case, your modified adjusted gross income must be under $173,000 for contributions to be fully deductible. If you are covered by a plan at work, traditional IRA contributions are fully deductible if you earn less than $58,000 or $92,000 as a joint filer. All contributions that you deduct and all investment gains earned in a traditional IRA are taxed at your normal income tax rate upon withdrawal.

Nondeductible Contributions to Traditional IRAs

You can make nondeductible contributions to a traditional IRA even if you don't qualify for tax deductible contributions due to your income level and coverage by a work-offered plan. Contributions to a nondeductible IRA come out of after-tax income, so you don't pay income tax on contributions at the time of withdrawal. However, any investment gains earned in a nondeductible IRA are taxed as normal income at the time of withdrawal. For this reason, many investors choose a Roth IRA -- which comes with some tax advantages -- rather than make nondeductible contributions to a traditional IRA.

Roth IRAs

Contributions you make to a Roth IRA are not tax deductible, meaning you make contributions with after-tax dollars. Unlike nondeductible contributions to a traditional IRA, however, Roth IRAs come with tax advantages. Investment gains earned in a Roth IRA are not taxable at the time of withdrawal as long as you wait five years to withdraw funds after opening an account and you take money out after the age of 59 1/2.

Other Tax Rules

IRAs are subject an early withdrawal penalty of 10 percent if you to you take money out before age 59 1/2. The penalty, however, applies only to tax deductible contributions and investment gains. For example, since Roth IRA contributions are not tax deductible, you can withdraw them early without penalty, but early withdrawals of your Roth IRA investment gains are subject to income tax and the 10 percent penalty. Traditional IRA account holders are required to start withdrawing funds starting at age 70 ½. Failure to make required withdrawals results in a 50 percent tax penalty. Roth IRA holders are never required to start withdrawing funds.

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