Tax treatment of IRAs, part 2: deductions and withdrawals

Let’s pick up the thread of a discussion we began earlier this spring about the tax treatment of individual retirement accounts (IRAs).

Traditional IRAs and Roth IRAs have historically had significant differences. As we noted in our March 31 post, for example, contributions to a traditional IRA are still tax deductible for those who qualify. Roth IRAs are not.

In this post, we will discuss the taxability of withdrawals and the deductibility of contributions.

Let’s start with deductibility of contributions on income taxes. There is a clear difference between Roth and traditional IRAs here.

Contributions to a Roth IRA are not tax deductible. For traditional IRAs, the amount of the deduction depends on whether the taxpayer has a retirement plan available at work.

Let’s also take note of the taxability of withdrawals. Another term for this is distributions.

Though withdrawals can be made at any time with both Roth IRAs and traditional IRAs, their taxability depends on several factors.

First of all, it is often possible for a taxpayer to “roll over” payments from an IRA that are received prior to retirement. This refers to the transfer of funds into a different account.

When a rollover is done, it generally means you don’t pay tax on it until such a time as you withdraw it from the new plan.

There are some pretty complicated rules regarding taking distributions (withdrawals) from IRAs. For example, if you take a distribution from an IRA before age 59 ½, you may not only have to include it in your taxable income. You may also face an additional 10 percent tax.

Source: IRS.gov, “IRA FAQs,” Accessed May 27, 2014