Congress authorized individual retirement arrangements to allow people with earned income to set aside a portion of their earnings in a tax-advantaged account. The kinds of tax advantages you get depend on the type of IRA you contribute to. All IRAs allow your investments to grow without creating a current tax liability, regardless of whether that growth comes from interest, dividends or capital gains.
When you withdraw money from a traditional IRA, you generally must pay on it, whether it's an initial investment or interest you've earned. With a Roth IRA, you do not pay tax on investment earnings but pay tax on income before putting it into the account.
Interest Income and Your IRA
The Internal Revenue Service considers most interest that you receive, or that is credited to an account that you can access, to be taxable income in the year you receive it. That includes interest on your bank savings accounts, certificates of deposit, corporate bond and government securities. If you have money in a credit union share account, you might receive dividends, but the IRS treats these payments as interest income.
Interest on some securities, such as municipal bonds, is exempt from federal income taxes. You can hold any of these interest-bearing investments in your IRA. The interest tax rate is simply your ordinary tax rate.
The taxes on all types of interest on investments in your individual retirement account are deferred for as long as the money remains in your IRA. This allows more of your money to be reinvested into additional investment products, which can make the value of your IRA increase more rapidly. You don't report interest income generated by investments held in your IRA when you file your federal income tax return.
Distributions from your traditional IRA are typically taxed as ordinary income. This includes the portion of your distribution that comes from your contributions as well as earnings produced by investments held in your IRA. Non-deductible contributions you made to your traditional IRA are not taxed when distributed, but any earnings produced by those contributions are taxable. Non-qualified distributions, those taken before you reach age 59 1/2, may be subject to an additional 10 percent tax penalty. Under a traditional IRA, interest earned is taxed, therefore, when you withdraw it from your account. If you put a tax-exempt municipal bond into your IRA, the interest paid by that bond, which would normal be exempt from federal income taxes, will be taxed as ordinary income.
Roth IRA Distributions
Any interest earned by investments in your Roth IRA grows tax-deferred as long as those earnings remain in the IRA. Once those earnings become qualified, typically after you have had a Roth IRA for at least five years and are at least 59-1/2-years-old, you can withdraw the earnings tax-free. If you withdraw the earnings from your Roth IRA before they become qualified, the earnings will be taxed as ordinary income and you might be subject to an additional 10 percent tax penalty.
In either case, the interest earned by investments in your Roth IRA is not taxed as interest. It is treated as a Roth IRA distribution, which may or may not be taxable.
You don't get a tax deduction for putting money into a Roth IRA, unlike a traditional IRA, since you get tax savings on your earnings instead. What combination of Roth and traditional IRAs is right for you depends on how you expect your earnings to grow and how you expect your tax rate to change as you age toward retirement.
2018 Tax Law Changes
IRA tax rules aren't changing substantially for 2018, but ordinary income tax rates are decreasing. That means you'll generally pay less tax on IRA distributions and interest in ordinary bank accounts.
2017 Tax Law
Income, including interest and IRA withdrawals, was generally taxed at a higher rate in 2017.
- Internal Revenue Service: Publication 590-A
- Internal Revenue Service: Topic 403 -- Interest Received
- Internal Revenue Service: IRA FAQs
- Internal Revenue Service: Topic 557 -- Tax on Early Distributions from Traditional and ROTH IRAs
- Internal Revenue Service: Publication 590-B
- Forbes: New: IRS Announces 2018 Tax Rates, Standard Deductions, Exemption Amounts And More
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.