Income taxes and retirement accounts are two topics that are complex and at times confusing. There is also quite a bit of information to research and sift through. This article hopes to help ease some of that confusion by giving a strong outline of the individual details, all in one place. So here is some vital information on each type of retirement account and how putting money into them, or taking money out of them, can affect your personal federal income taxes.
Traditional Individual Retirement Account
As the name states, a traditional individual retirement account, or IRA for short, is an account that an individual personally opens and funds. The account can be opened with a bank, credit union, or financial advisor, to name a few. The IRS allows a deduction from income for money contributed to an IRA during any given tax year; however, it is limited. In general, for tax year 2025, you can contribute and deduct up to $7,000 if you are under 50 and $8,000 if you are 50 or older. This limit applies to the total you contribute to any and all IRA’s, not each one separately, including Roth ones. It is also important to understand the IRS will penalize you if you contribute more than that. The upside is that as long as your income is not above the IRS threshold, you can deduct the full amount contributed to your traditional IRA from your income before income tax is calculated.
So how does it affect your federal income tax if you take money out of your traditional IRA? If you are over 59 ½, all withdrawals are completely taxable, and this is because a deduction from tax was already received at the time the money was contributed. There are exceptions if you did not qualify for the deduction the year of contribution, so keep that in mind. If you are younger than 59 ½, you will also be charged a 10% penalty in addition to the income tax you owe. There are exceptions to the penalty, as follows:
-Medical expenses exceeding 7.5% of your AGI
-Qualified higher education expenses
-First time home buyer, limited to $10,000
-Birth or adoption expenses, limited to $5,000
-Death, disability, or terminal illness
-Health insurance while unemployed
-Taking periodic equal payments from the plan for at least 5 years
There are additional exceptions that are rare, and available on the IRS website.
Roth IRA
Roth IRA’s are very similar to traditional IRA’s in how you create them and fund them. You are limited as to how much you can contribute each year as stated above. The major difference is that the contributions are not deductible from your income for tax purposes.
Withdrawing money from a Roth IRA generally speaking is tax-free. Since there was no deduction for the contributions, income tax was essentially already paid on the funds. It is important to note that the money you put into a Roth IRA is always tax-free when withdrawn. Any income tax or penalties due would be calculated on the earnings, meaning any interest and dividend the money earned during investment. This can happen when the money is withdrawn early. Early here can refer to not being 59 ½ or older, with the same guidelines as traditional IRA’s. With the Roth IRA, early can also mean the account was not open for at least 5 years before withdrawing.
401K
A 401K retirement plan is one established by an employer as an employee benefit. Both the employer and employee will contribute to the plan. These contributions are made by the employee pre-tax, meaning the amount is not included in federal taxable income. That means that like a traditional IRA, money a person puts into his or her own 401K receives a tax benefit.
Also similar to a traditional IRA, since there was a tax deduction at the time of contribution, when the money is withdrawn from a 401K, it is then taxable income. The same rules also apply for early withdrawals and the 10% penalty as they do for traditional IRA’s. The one difference is that to avoid the penalty, withdrawals from 401K’s do not include the exceptions for education expenses, first time home purchases, or health insurance premiums while unemployed.
Pension Plan
Pension plans are completely funded by employers as a benefit for the employees. While this is a great job benefit, contributions offer the employee no income tax benefit.
Withdrawals from a pension plan are completely taxable no matter when they are taken. The money is also subject to the 10% penalty if withdrawn before the age of 59 ½. To avoid the 10% penalty the rules are the same for pension plans as they are for 401K’s.
It is important to note that for some occupations, such as police officers and public school teachers, if you serve the job a certain number of years you may collect your retirement funds without the 10% penalty no matter your age when you retire from the job.
This information is by no means extensive enough to include all the details you can run into in unusual situations, but gives a good basis from which to start. This article also only discusses the affects on federal income taxes, since the individual states have their own rules and taxation. There are also other, less common types of retirement accounts, such as Roth 401K’s and Simple IRA’s, so keep those in mind as well. It is definitely important to know the tax consequences of contributing to and withdrawing from any retirement account in your financial planning. It is also worth noting that having a good accountant can help with the information, and decisions you make regarding your retirement funds.
Income taxes and retirement accounts are two topics that are complex and at times confusing. There is also quite a bit of information to research and sift through. This article hopes to help ease some of that confusion by giving a strong outline of the individual details, all in one place. So here is some vital information on each type of retirement account and how putting money into them, or taking money out of them, can affect your personal federal income taxes.
Traditional Individual Retirement Account
As the name states, a traditional individual retirement account, or IRA for short, is an account that an individual personally opens and funds. The account can be opened with a bank, credit union, or financial advisor, to name a few. The IRS allows a deduction from income for money contributed to an IRA during any given tax year; however, it is limited. In general, for tax year 2025, you can contribute and deduct up to $7,000 if you are under 50 and $8,000 if you are 50 or older. This limit applies to the total you contribute to any and all IRA’s, not each one separately, including Roth ones. It is also important to understand the IRS will penalize you if you contribute more than that. The upside is that as long as your income is not above the IRS threshold, you can deduct the full amount contributed to your traditional IRA from your income before income tax is calculated.
So how does it affect your federal income tax if you take money out of your traditional IRA? If you are over 59 ½, all withdrawals are completely taxable, and this is because a deduction from tax was already received at the time the money was contributed. There are exceptions if you did not qualify for the deduction the year of contribution, so keep that in mind. If you are younger than 59 ½, you will also be charged a 10% penalty in addition to the income tax you owe. There are exceptions to the penalty, as follows:
-Medical expenses exceeding 7.5% of your AGI
-Qualified higher education expenses
-First time home buyer, limited to $10,000
-Birth or adoption expenses, limited to $5,000
-Death, disability, or terminal illness
-Health insurance while unemployed
-Taking periodic equal payments from the plan for at least 5 years
There are additional exceptions that are rare, and available on the IRS website.
Roth IRA
Roth IRA’s are very similar to traditional IRA’s in how you create them and fund them. You are limited as to how much you can contribute each year as stated above. The major difference is that the contributions are not deductible from your income for tax purposes.
Withdrawing money from a Roth IRA generally speaking is tax-free. Since there was no deduction for the contributions, income tax was essentially already paid on the funds. It is important to note that the money you put into a Roth IRA is always tax-free when withdrawn. Any income tax or penalties due would be calculated on the earnings, meaning any interest and dividend the money earned during investment. This can happen when the money is withdrawn early. Early here can refer to not being 59 ½ or older, with the same guidelines as traditional IRA’s. With the Roth IRA, early can also mean the account was not open for at least 5 years before withdrawing.
401K
A 401K retirement plan is one established by an employer as an employee benefit. Both the employer and employee will contribute to the plan. These contributions are made by the employee pre-tax, meaning the amount is not included in federal taxable income. That means that like a traditional IRA, money a person puts into his or her own 401K receives a tax benefit.
Also similar to a traditional IRA, since there was a tax deduction at the time of contribution, when the money is withdrawn from a 401K, it is then taxable income. The same rules also apply for early withdrawals and the 10% penalty as they do for traditional IRA’s. The one difference is that to avoid the penalty, withdrawals from 401K’s do not include the exceptions for education expenses, first time home purchases, or health insurance premiums while unemployed.
Pension Plan
Pension plans are completely funded by employers as a benefit for the employees. While this is a great job benefit, contributions offer the employee no income tax benefit.
Withdrawals from a pension plan are completely taxable no matter when they are taken. The money is also subject to the 10% penalty if withdrawn before the age of 59 ½. To avoid the 10% penalty the rules are the same for pension plans as they are for 401K’s.
It is important to note that for some occupations, such as police officers and public school teachers, if you serve the job a certain number of years you may collect your retirement funds without the 10% penalty no matter your age when you retire from the job.
This information is by no means extensive enough to include all the details you can run into in unusual situations, but gives a good basis from which to start. This article also only discusses the affects on federal income taxes, since the individual states have their own rules and taxation. There are also other, less common types of retirement accounts, such as Roth 401K’s and Simple IRA’s, so keep those in mind as well. It is definitely important to know the tax consequences of contributing to and withdrawing from any retirement account in your financial planning. It is also worth noting that having a good accountant can help with the information, and decisions you make regarding your retirement funds.
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