How IRA taxes work

When planning for retirement, you’ve likely given some thought to the types of savings accounts you need to fund for your post-workforce lifestyle. If you’re self-employed or looking for a savings vehicle outside of your employer-sponsored 401(k), your retirement plan may include an individual retirement account (IRA), a tax-advantaged financial product that allows you to contribute money and experience tax-deferred growth.

The type of IRA you choose will determine when contributions, earnings and withdrawals are taxed, important information you need to know for retirement planning. In fact, according to Thrivent’s Retirement Readiness Survey, about two-thirds of retirees say if they had to advise their younger selves on a financial matter, they would tell them to learn how taxes impact retirement savings.

Here, we break down how IRAs are taxed so you can work on your financial plan with tax-efficiency in mind.

We'll cover:

• Traditional vs Roth IRA contributions
• Traditional IRA eligibility & contribution deductibility
• Roth IRA eligibility & contribution deductibility
• How IRA earnings are taxed
• How IRA withdrawals are taxed by type
• IRAs & required minimum distributions (RMDs)

The two most common types of IRAs are traditional and Roth. They’re similar in that both accounts act as savings vehicles for retirement, and both have annual contribution limits. For 2023, it’s $6,500 for individuals, or $7,500 if you’re 50 or older because of catch-up contributions.

But there are also a couple of important differences, primarily in how they're taxed, when they’re taxed and who can participate.

Traditional IRAs are open to anyone with earned income from wages, salaries and tips (or if your spouse has earned income and you file jointly.)

With traditional IRAs, contributions are generally pre-tax, so the money has not yet been taxed when it goes into your account.

You can fully or partially deduct traditional IRA contributions from your taxes the year they are made unless you or your spouse are covered by a retirement plan at work, and do not meet the IRS income limits to deduct the contribution. These restrictions are based on your filing status and modified adjusted gross income (MAGI).

• If you make less than the MAGI range listed, a full deduction is available.
• If you make between the MAGI listed, a partial deduction is available.
• If you make equal to or more than the maximum MAGI listed, no deduction is available.

Roth IRAs require you or your spouse to have earned income, similar to traditional IRAs. However, they have income limits to participate.

Depending on your filing status and MAGI, you only may be eligible to contribute a reduced amount to a Roth IRA, or you might not be allowed to open one at all.

• If you make less than the MAGI range listed, you can contribute the full amount to a Roth IRA.
• If you make between the maximum MAGI listed, you can contribute a reduced amount to a Roth IRA.
• If you make equal to or more than the maximum limit listed, you can’t contribute anything to a Roth IRA. (Check out the backdoor Roth IRA if this applies to you.)

Roth IRA contributions are made after you’ve already paid taxes on the money, so they are not tax-deductible in the year they are deposited.

Whether you invest your money in a traditional or Roth IRA, both benefit from the power of compounding, which helps your retirement savings account grow.

Those earnings come with tax implications, though. When it comes to IRA tax rules, there are some differences between the two types of IRAs:

• Traditional IRA earnings grow tax-deferred, so you won’t pay taxes on the earnings until it’s time for withdrawal.
• Roth IRA earnings grow tax-deferred, too, but if you meet the eligibility for a qualified distribution, you’ll never pay taxes on the earnings.

Doing taxes

Doing taxes

Is your financial plan tax-efficient?

Are you prepared for your tax liability once it comes time to retire? Investing in a variety of tax-advantaged accounts can help you reduce or even eliminate some tax consequences in later years.

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As with contributions, there are some differences between how traditional and Roth IRA withdrawals are taxed.

Since traditional IRA contributions and earnings are tax-deferred as you invest and grow your retirement account, withdrawals are taxable as ordinary income.

If you want to withdraw these funds before 59½, you’ll be subject to a 10% penalty, unless you meet one of the exceptions defined by the IRS:

• Death or total and permanent disability of the participant/IRA owner
• You set up a Substantially Equal Periodic Payment (SEPP) plan, which allows you to withdraw a set annual amount determined by the IRS over a period of the longer of five years or until you turn 59½
• The IRS levies the plan to satisfy your tax debt
• You’re a qualified military reservist called to active duty
• You’re withdrawing IRA funds that exceed the annual contribution limit before the extended due date of your tax return
• You’re rolling the money over into another retirement plan or IRA within 60 days of withdrawal , you are limited to doing this only once in a 12-month period
• You are using the money for:
  
  • Qualified higher education expenses
  • Up to $10,000 for a home, and you’re a qualified first-time homebuyer
  • Unreimbursed medical expenses
  • Health insurance premiums paid while unemployed

You can withdraw Roth IRA contributions tax-free and penalty-free at any point, even if you haven’t turned 59½ yet.

Earnings however, may be subject to taxes and/or penalties. Unless you meet the requirements for a “qualified distribution” earnings will be taxable, and unless you meet one of the IRS penalty exceptions, the earnings will be subject to the 10% penalty as well.¹

Traditional IRAs also are subject to required minimum distributions. This means you have to start withdrawing a specified amount—your retirement account balance divided by your life expectancy—between the ages of 73 and 75, depending on your birth year.

Keep in mind that once you withdraw your annual RMD, the money will be taxed at your current ordinary income rate. The federal income tax impact is similar to the income you earn from working at a job—the higher your income for the year, the higher your tax rate.

Roth IRAs are not subject to RMDs for the original IRA owner, but Roth IRA beneficiaries will be subject to RMDs.

As you’re planning for retirement, think about your future tax rate on IRA withdrawals.

• Do you plan to be in a higher tax bracket in retirement? If so, you might want to invest in a Roth IRA for tax-free withdrawals down the road.
• If you expect to be in the same or a lower tax bracket, a traditional IRA can maximize account growth in the years leading up to retirement while offering immediate tax advantages.

If you already fund one or both types of IRAs, talk to a Thrivent financial advisor to help you create a financial plan that prioritizes IRA tax efficiency.