“Will I owe more in taxes?” is a question a lot of us are asking as we head into the 2021 tax season. If you withdrew money from an IRA in 2021, you may end up owing taxes when you file your return—this depends on several factors, including your withholding elections.
Consult your tax advisor for help in determining the right amount of withholding, given your financial and tax situation going forward. In the meantime, here is some information that may be helpful in understanding the tax impact of IRA withdrawals.
Have You Withdrawn From a Traditional IRA?
If you took money or property out of your Traditional IRA, it will most likely be taxable. Traditional IRAs are primarily funded with money that has not yet been taxed, either because the IRA owner was able to take a tax deduction for the contribution for the year in which it was made, or the IRA owner rolled over tax-deferred savings from an employer retirement plan. Any investment earnings in a Traditional IRA are also tax-deferred until they are withdrawn from the IRA. The only tax-free money coming out of a Traditional IRA are contributions that were not tax deductible when made, and any after-tax assets rolled over from an employer’s 401(k) plan into an IRA. The tax rules for Traditional IRAs mandate that each withdrawal consists of a proportionate share of the pre-tax and post-tax money in all your Traditional (as well as SEP and SIMPLE) IRAs. So even if you have some nondeductible or after-tax contributions, most of your IRA withdrawals must be included as taxable income on your tax return.
Having more taxable income in a year, regardless of whether it bumps you up into the next tax bracket, could increase your tax liability for the year. If you did not have enough withheld from your paychecks or your IRA withdrawals to cover your tax liability, you will owe money to the IRS at tax time rather than receive a tax refund.
Have You Made a Withholding Election?
The tax rules for Traditional (and SEP and SIMPLE) IRAs also mandate that the IRA custodian withhold 10% of the gross amount withdrawn for federal income taxes, unless you waive withholding or elect to withhold an amount higher than 10%.1 This withholding is remitted to the IRS as a prepayment of the potential tax liability that the additional taxable income will trigger for you. When you requested the withdrawal, you were probably given a withholding notice and a form to make a withholding election. If you chose to waive withholding, you may owe taxes when you file your tax return because that IRA withdrawal has not yet been taxed. But remember, your tax liability is based on all your income for the year adjusted for deductions and credits—tax is not calculated just on your IRA withdrawal. When you amount to all your income and the tax you have already paid from other sources throughout 2021, you may have already paid your tax liability for the year.
If you don’t remember if any money was withheld on your IRA withdrawal, don’t worry. Your IRA custodian must send you a copy of IRS Form 1099-R by January 31. This form will tell you the gross amount distributed from your IRA and any amount that was withheld.
Did You Know Withholding is Taxable Too?
If you did have tax withheld on your IRA withdrawal, you’ll be thanking yourself come tax time. But did you know the amount sent to the IRS as a prepayment of your tax liability is also taxable? For example, if you received $10,000 from your Traditional IRA (that contains only pre-tax assets), and you elected 10% federal withholding, you would have received a $9,000 payment and the IRS would have received the $1,000 your IRA custodian withheld—but all $10,000 must still be claimed as taxable income on your tax return.
Are You Younger Than 59½?
The tax advantages associated with saving in an IRA or qualified retirement plan are meant to encourage individuals to save for retirement. Similarly, an additional tax assessed on IRA withdrawals taken before age 59½ is meant to discourage individuals from withdrawing their retirement savings before they reach retirement age. If six months have not passed since your 59th birthday when you take your IRA withdrawal, you will owe an additional 10% “early distribution” tax on the taxable portion of your withdrawal, unless you meet one of the IRS-approved exceptions (e.g., disability, higher education expenses).
Have You Withdrawn From a Roth IRA?
Roth IRA contributions can only be made on an after-tax basis. Roth IRA investment earnings are tax-deferred and may never be taxed if withdrawn as part of a qualified distribution. If a distribution is not qualified, you may still be able to avoid taxes based on the distribution ordering rules. The after-tax contributions are distributed first, and the taxable earnings are last to leave the Roth IRA. This means that most Roth IRA distributions are not taxable. Therefore, they are not subject to the withholding rules.
If you took a withdrawal from your Roth IRA that was not qualified2, you will need to track your basis and earnings in your Roth IRA to determine if any of the taxable investment earnings were included in the amount you withdrew in 2021. If they were not, your withdrawal will be tax-free. If earnings were included in your withdrawal, only the amount of earnings need be included in your income for 2021. If you were under the age of 59½ at the time of withdrawal, you would also be subject to the 10% early distribution tax on the taxable earnings amount withdrawn.
For More Information
If you have any questions about making a withholding election when taking a distribution from your STRATA Trust account, please visit our FAQ section: https://www.stratatrust.com/frequently-asked-questions/#distributions
1 State tax withholding may also apply depending on your state’s income tax laws.
2 To take a qualified distribution from a Roth IRA, you must have had a Roth IRA for at least 5 years and be age 59½ or older, disabled, buying a first home, or a beneficiary of a Roth IRA.