Saving money in an account with tax benefits like an IRA can reduce the total amount of tax you pay, but an IRA doesn't let you avoid taxes entirely. Depending on the type of IRA you open, you either have to pay income tax upfront or upon withdrawal. Taxable IRA distributions are reported as ordinary income and are subject to income tax rather than the long-term capital gains tax.
When you sell an asset at a price that is higher than the amount you paid for it, you realize a capital gain. Capital gains are normally subject to a capital gains tax: a short-term gains tax equal to your normal income tax rate applies to assets you hold a year or less and a long-term gains tax of up to 15 percent applies to assets held longer than a year. While the funds you contribute to an IRA can be invested in stocks, mutual funds and other assets that generate capital gains, IRAs defer taxes on investment gains. Tax deferral means you don't owe taxes on capital gains, interest or dividends, but you may owe income tax on funds you withdraw.
A traditional IRA is type of retirement account where your contributions are tax deductible if you meet certain employment and income requirements. Contributions are fully tax deductible if you are single and don't have access to a retirement at work or your adjusted gross income is under $58,000. The income limit is $92,000 for joint filers. You have to pay income tax on all tax deductible contributions and investment gains on traditional IRAs upon withdrawal.
A Roth IRA also offers tax benefits, but the benefits come during retirement rather than the year you contribute. With a Roth IRA, you cannot deduct your contributions, so you have to fund the account with after-tax income. On the other hand, you generally don't have to pay income tax on contributions or investment gains upon withdrawal. In essence, Roth IRAs let you pay taxes upfront to avoid tax during retirement, while traditional IRAs let you delay taxation until retirement.
Reporting IRA Withdrawals
Since IRA withdrawals may count as ordinary taxable income upon withdrawal, you have to report distributions on your income tax return. When you receive an IRA distribution, your financial institution should send you Form 1099-R documenting the withdrawal. You report your total IRA distributions on line 15a of Form 1040 and the taxable portion of IRA distributions on line 15b.
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.