When Do You Pay Taxes on Money in Your IRA?

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When you’re taxed on IRA funds varies, depending on whether you have a traditional or a Roth IRA. Here are the rules you need to know about. 

IRAs are retirement savings accounts you can open with any brokerage firm. You can invest in an IRA if you don’t have a workplace 401(k) plan and you want to save for retirement in an account that offers tax benefits. If you do have a 401(k), you can still choose to invest in an IRA and may want to do so, since these accounts tend to have more investment options than 401(k)s do — but you’d want to max out your employer match first before doing so.

If you put money into an IRA, it’s important to understand how taxes work for this type of account, since they are tax-advantaged accounts. But that doesn’t mean you are never taxed on the money you contribute to them. Here’s what you need to know about how taxes work for IRA accounts.

When you have a traditional IRA, here’s how taxes work

The rules for when you pay taxes on the money in your IRA differ depending on the kind of IRA you have. If you have a traditional IRA, you get to take a tax deduction for the money you contribute, up to annual limits. This means you contribute money to the account you have not yet been taxed on.

When your money is in your IRA, it grows tax-free as long as it’s in the account. So you don’t have to pay taxes as your retirement nest egg gets bigger. You will only be taxed when you take money out of this account.

If you wait until you’re 59 1/2, you get to take money out without penalty and are taxed at your ordinary tax rate. If you withdraw money early and don’t qualify for an exception, you will owe a 10% penalty for early withdrawals, plus be taxed at your ordinary tax rate.

You are also required to begin taking money out of your traditional IRA starting at age 72 or starting at age 73 if you didn’t already turn 72 by Dec. 31, 2022. You must begin taking money out at this point because the IRS wants to be sure the funds are taxed. The mandated withdrawals are called required minimum distributions (RMDs) and there are IRS tables that you can consult to tell you how much you must take out.

For many people, deferring the taxes due on funds in an IRA makes sense because they are in a lower tax bracket in retirement when they begin withdrawing this money than their tax bracket when they’re working and saving for the future.

When you have a Roth IRA, here’s how taxes work

If you invest in a Roth IRA instead of a traditional one, taxes work differently. You don’t get to deduct contributions. You contribute to this account with money you already were taxed on.

The money in your Roth IRA can grow without gains being taxed, as well. And if you want to, you can withdraw the contributions you made without a tax penalty at any time — although you usually shouldn’t. Remember, you’re going to want that money invested so it can help you grow your nest egg.

Since you were already taxed on your contributions, you get to take money out of your Roth IRA without being taxed on withdrawals. And you don’t have to take RMDs at all, so you can just leave your money invested to grow as long as you want.

If you think you will be in a higher tax bracket in retirement, a Roth could be the way to go as it would be better to save on taxes later.

Knowing when you pay taxes on traditional and Roth IRAs can help you make an informed choice about which of these accounts to use. Decide if you want your tax savings now or in the future and pick the account that makes sense.

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