The tax implications of IRAs can be broken down into the following categories:
Taxing of deductible and non-deductible contributions
Withdrawals are taxed if the original contribution was deductible in the first place. If the contributions were not deductible, then the withdrawals will not be taxed.
Taxes on Excess Contributions
There are limits on annual contributions but a participant may elect to make additional contributions. Those will be taxed at 6% if the money is not removed from the account before the tax filing deadline. To avoid the penalty, the excess money and earnings can be removed from the account prior to the filing date, although the earnings are taxable for that year.
It is possible to move the funds from another IRA or a qualified retirement plan such as a 401(k) within 60 days. This will allow for the funds to keep their tax-deferred status while the funds are moved into another 401(k) plan.
Withdrawals usually start at the age of 59 1/2; otherwise, there is a 10% penalty. However, there are some exceptions to this rule. Penalty-free withdrawals can be made before the retirement age if the participant qualifies. The qualifications include:
- Withdrawal by the beneficiary in case of owner’s death or disability.
- Withdrawals taken in equal periods determined by the participant’s life expectancy or the joint life expectancy of the participant and the beneficiary.
- Withdrawals used to pay for medical expenses that excel 7 1/2% of your AGI.
- Withdrawals used to pay for medical insurance if the owner has received unemployment for more than 12 weeks.
- Withdrawals used to pay for the first home, subject to a $10,000 limit.
- Withdrawals used to pay for higher education expenses.
All of these withdrawals are subject to ordinary income taxes but there is no additional penalty for this premature distribution.
There are three methods for premature withdrawals:
- Life Expectancy Method: There are IRS tables that determine life expectancy of the owner or the joint life expectancies of the owner and a beneficiary. The withdrawal amount is calculated by dividing the balance at the beginning of the year by the factor found in the IRS life expectancy tables. For each year that passes by, the life expectancy factor is reduced by one.
- Amortization Method: The life expectancy is determined using the IRS tables mentioned above. The annual withdrawal amount is determined by applying an assumed earnings rate over the life expectancy. Generally, the rate must be within 120% of the applicable federal long-term rate. Once the rate is determined, the withdrawal remains fixed each year.
- Annuity Factor Method: Similar to the second method, but the withdrawal amounts are calculated using a different set of life expectancy tables than those used by the life insurance agency, which is the UP-1984 Mortality Table.
Regardless of which method is used, the process must continue for a minimum of five years or until age 591/2.