An IRA provides a way to set aside money during your earning years to provide income during retirement with some significant tax advantages. Because the purpose of the account is to provide retirement income, any withdrawals from your IRA account are considered ordinary income and may be taxable depending on the type of contribution and account that you have. Even if your investments inside of your IRA make capital gains and increase in value, this is not a capital gain as far as the IRS is concerned since the money inside of your IRA grows tax-free.
The best thing about an IRA is that as long as you leave the money in the account, it earns interest tax-free. With a Traditional IRA, you'll pay taxes the day you take the money out. In addition, you'll owe a 10 percent penalty if you take the money out before the age of 59 1/2. With a Roth IRA, however, you'll pay zero taxes on the money you take out, as long as you wait until the age of 59 1/2 or beyond. You'll need to have had the money in the account for at least five years. If you choose to take the money out before 59 1/2 or before the five years are up, you'll owe taxes.
Taxable as Income
Taxable withdrawals from your IRA account are reported on your federal income tax return as ordinary income and must be added to all of your other income from any source — wages, salaries, tips and interest income. The taxable withdrawals are taxed at your normal income tax rate, which could be as high as 37 percent, compared to the maximum long-term capital gains tax rate of 20 percent for higher-income taxpayers, with most taxpayers paying a lower capital gains rate of 15 percent.
While you pay no tax on contributions that you make to a traditional IRA, all withdrawals are taxable at your regular income tax rates. For example, you made a tax-deductible contribution of $10,000 to your traditional IRA, and over many years the value of the account grew to $50,000. Later, you withdraw the entire balance, and you owe taxes on the total withdrawal as if it were normal income, at your income tax rate. If you were in the 24 percent tax bracket, your tax bill would be $12,000.
Roth IRA withdrawals are completely tax-free when taken at retirement, representing a significant benefit to the account owner. This is an advantage over a traditional IRA or overinvesting outside an IRA and paying capital gains taxes on the growth of your investments. Although you must pay income tax at the regular rate on Roth contributions in the year you make them, you get tax-free growth on your investments for the life of the account.
Nondeductible Traditional IRA
A nondeductible traditional IRA contribution has the fewest advantages from a tax perspective. You receive no initial tax break when you make the contribution, and while you pay no taxes on the portion of your withdrawals proportionate to your contributions, you will pay taxes at normal income tax rates for the amount of your withdrawal proportionate to investment gains. For example, if your IRA is made up of 30 percent nondeductible contributions, and 70 percent investment gains, and you withdraw $10,000, you will pay taxes on $7,000 of your withdrawal at your normal income tax rates. If you had made the same investment in an after-tax account, you would pay taxes on the $7,000 at your long-term capital gains rate, which is probably much lower than your income tax rate.
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