Traditional and ROTH IRA Tax Benefits
Basic IRA Tax Rules
It’s important to know the tax rules that apply to Traditional and Roth Individual Retirement Arrangement, or IRAs. Distributions before age 59½ and failing to take required minimum distributions (RMDs) could result in substantial penalties and taxes. Many customers are not fully aware of the IRS requirements, and they will look to you for guidance.
Some or all your contributions to a Traditional IRA may be deductible. You may also be eligible for a tax credit equal to a percentage of your contribution. Amounts in your traditional IRA, including earnings, generally are not taxed until distributed to you. IRAs cannot be owned jointly. However, any amounts remaining in your IRA upon your death will be paid to your beneficiary or beneficiaries.
To contribute to a traditional IRA, you must be under age 70½ at the end of the tax year. You, and/or your spouse if you file a joint tax return, must have taxable compensation, such as wages, salaries, commissions, tips, bonuses, or net income from self-employment. Taxable alimony and separate maintenance payments received by an individual are treated as compensation for IRA purposes.
Compensation does not include earnings and profits from property, such as rental income, interest and dividend income, or any amount received as pension or annuity income, or as deferred compensation.
Figure your allowable deduction using the worksheets in the IRS Form 1040 Instructions, IRS Form 1040A Instructions or in IRS Publication 590 [Individual Retirement Arrangements (IRAs). Consult the IRS website for all IRS forms, publication and additional information.
Distributions from a traditional IRA are fully or partially taxable in the year of distribution. If you made only deductible contributions, distributions are fully taxable. Use Form 8606 to figure the taxable portion of withdrawals.
Distributions made prior to age 59½ may be subject to a 10% early distribution penalty in addition to federal and state taxes that may apply. You also may owe an excise tax if you do not begin to withdraw minimum distributions by April 1st of the year after you reach age 70½. These additional taxes are figured and reported on Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts. Refer to the Form 5329 Instructions for exceptions to the additional taxes. All IRS forms are found on IRS.gov.
The early distribution penalty will not apply if the account owner becomes disabled or dies. In addition, the account owner may be able to withdraw money without penalty to:
- Purchase a home for the first time ($10,000 lifetime cap)
- Fund qualified higher education expenses
- Cover deductible medical expenses
- Pay health insurance premiums as long as the person has been receiving unemployment compensation for at least 12 weeks
- Pay a federal tax levy
Contributions to a Roth IRA are not deductible (and you do not report the contributions on your tax return), but you also are not taxed on qualified distributions or distributions that are a return of contributions. In addition, you do not have to be under age 70½ to contribute to a Roth IRA. To be a Roth IRA, the account or annuity must be designated as a Roth IRA when it is set up. For more information on Roth IRA contributions, consult the IRS website.
Special early payout exception. For people who retire early (before age 59½), the IRS permits systematic payments from a Traditional IRA before retirement with no additional penalties if certain conditions are met. In general, the rules require that distributions be made as part of a series of “substantially equal periodic payments” that continue for at least 5 years or until the account owner reached age 59½, whichever is later. The rules governing early-payout can be complex. Consult the IRS website for more information.
Distributions between ages 59½ and 70½. Distributions from a Traditional IRA are subject to ordinary income taxes. At age 59½, early distribution penalties no longer apply. Distributions can generally be made from a Roth IRA tax-free during this time.
Distributions after age 70½. After age 70½, your customers must begin taking required minimum distributions (RMDs) from Traditional IRAs and other pre-tax retirement accounts. This requirement does not apply to a Roth IRA.
It's important to calculate the RMD accurately every year. There’s a 50% federal excise tax penalty on any amount that’s less than the RMD—if the distributions does not meet the minimum required. Consult the IRS website for more information.
Required beginning date. The IRS requires people to begin withdrawing money from a Traditional IRA according to this schedule:
Roth IRA tax considerations. Roth IRA distribution rules differ from those that apply to Traditional IRAs. Distributions from a Roth IRA after age 59½ are generally tax-free and penalty-free, provided the these conditions are met:
- The Roth IRA account must be open for at least five years; AND
- The Roth IRA owner must meet one of these criteria:
- Is over age 59½
- Qualifies for a first-time homeowner distribution ($10,000 lifetime cap)
- Becomes permanently disabled
Otherwise, Roth IRA distributions of earnings may be subject to ordinary income taxes and an additional 10% early distribution penalty. Roth IRAs are not subject to required minimum distribution rules (except after the death of the account owner).