How Are IRAs Taxed, and When Do You Owe the Government?

As the old saying goes: Nothing is certain except death and taxes. So it shouldn't come as a surprise that even your retirement plan comes with tax obligations. However, the exact amount of money you owe the IRS, as well as the circumstances under which you need to pay taxes on your individual retirement account, depend on which type of account you own. So whether you decide on a CARL self-directed traditional IRA or a Roth IRA, you should always have a firm understanding of how your account will be taxed.

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Talking Taxes – Consult With an Expert

Before we get into the details, we need to make one thing clear: CARL doesn't know your financial situation, so we can't give you financial advice or help you determine exactly how much tax you owe or will owe as an IRA owner. What we can do is present you the general taxation rules surrounding traditional IRAs and Roth IRAs so you can make sure you pay your taxes on time.

While these rules have been unchanged for decades, it's entirely possible that they may change again within your lifetime. So if you set up your CARL IRA today to provide you with a steady income in 30 to 40 years, new legislation may change the rules of how IRAs work in the intervening time.

Therefore, please always consult with a professional tax advisor when it comes to your personal taxes.

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General Concepts Concerning IRA Taxes

There are many different ways for you to save money for retirement. High net-worth individuals, in particular, rely on individual retirement accounts (IRAs) and self-directed IRAs (SDIRAs), as these usually provide you with the best options for saving and growing your wealth through active investment. This type of account has been created specifically for the needs of retirees, which is why IRAs come with numerous income tax advantages which standard investment accounts don't offer.

Whether we're talking about deposits into your retirement account or withdrawals from it, we're always talking about income tax. Your money will be taxed according to your tax bracket and the amount of taxable income you have. This allows you to determine beforehand how much you'll have to pay in taxes.

Naturally, the IRS wants to ensure that only people saving for retirement enjoy these tax benefits. That's why traditional IRAs and Roth IRAs are subject to various regulations, from income limits and required minimum distributions (RMDs) to rules on which percentage of your money is subject to income tax under which circumstances. In other words: If you overstep the boundaries set by the IRS (for example, by depositing more money than you're allowed annually or by forgetting to pay taxes on non-deductible deposits or IRA withdrawals), you will have to pay a penalty. Repeated violations of the rules may even cause the IRS to consider your account to no longer qualify as a retirement plan, which will have adverse tax repercussions.

How Much Tax Do You Pay on a Traditional IRA?

Traditional IRAs – and most special types of IRAs such as SEP IRAs and SIMPLE IRAs – follow the standard model of tax-deductible contributions (deposits into the account) while applying income tax to distributions (IRA withdrawals).

This means that you can deposit money up to your current contribution limit into your account, which will lower the amount of taxable income you have for that year. For example, if you earned $200,000 in that year and deposited $6,000, you will only need to pay taxes on the remaining $194,000.

However, once you withdraw money from your individual retirement account, income tax applies both to the original funds you've contributed and any gains you received from your investment. If you withdraw money from your traditional IRA before you've reached the age of 59.5, you'll also have to pay a penalty in addition to the taxes you owe. Currently, that penalty stands at 10% of the withdrawn capital.

There are several circumstances under which the IRS waives the penalty for withdrawing from a traditional IRA before the age of 59.5. These include qualified first-time home purchases (up to $10,000), health insurance premiums paid while unemployed, unreimbursed medical expenses, and qualified education expenses.

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Watch Out for RMDs

"Required minimum distribution" is the IRS term for a mandatory IRA withdrawal from your IRA. You need to make these withdrawals once you've reached a certain age – as of 2022, this stands at 72. Once you've reached this age, you need to take your first required minimum distribution no later than 1 April the following year and then every tax year after that. In contrast to traditional IRA contributions, these RMDs are subject to income tax as per your tax bracket at the time of withdrawal. Should you not withdraw the required amount, the IRS will charge you a 50% penalty tax on the amount of money you should have withdrawn! If you run the risk of not withdrawing the minimum amount, keep these things in mind:

  • RMDs that the IRA owner didn't take accumulate over time. Each year, the amount of money on which you have to pay a 50% tax grows. You'll usually lose less money if you just withdraw the minimum amount as taxable income from your traditional IRA, even if you don't need it.
  • You can always withdraw more than the required minimum. So if you run the risk of having multiple tax years’ worth of RMDs pile up, you can simply withdraw the full amount of RMDs you didn't take yet, to get rid of the 50% tax. This might happen if you cannot withdraw money for one year because your capital is invested in illiquid assets.
  • If you withdraw more than the minimum one year, the amount exceeding the minimum does not decrease the amount you'll need to withdraw the next year as a RMD.

How Are Roth IRAs Taxed?

Roth IRAs are only available for people up to a certain modified adjusted gross income (MAGI). Though if you fall within this category, they can offer several benefits over traditional IRAs.

First and foremost, Roth IRAs feature non-deductible IRA contributions and tax-free distributions – you'll be able to put after-tax money into your account and withdraw money without needing to pay income tax on it, as long as you follow the additional rules of Roth IRAs. These make it necessary to distinguish between contributions (money you deposited in the account) and earnings (earnings derived from investing your contributions). This is also why you should always keep track of how much of your account balance is Roth IRA contributions and how much is earnings. If you have $10,000 on your Roth IRA and $3,000 of this sum were made from investments, this money is now subject to slightly different rules:

  • You can withdraw any amount of money from a Roth IRA tax-free if you're 59.5 years of age and if the money has been in the account for at least five years.
  • You can withdraw IRA contributions tax-free before you've reached the age of 59.5, but you'll have to pay tax on any earnings you withdraw before you've reached that age.
  • There are no required minimum distributions for Roth IRA owners.

When you set up a Roth IRA, you should ask your broker to pay out contribution money first instead of earnings money before you've reached age 59.5 – this way, you may avoid paying tax for earnings money you've withdrawn early.

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Using Your IRA to Invest in Your Future

There are many things that will eat away at your retirement account: your tax returns, inflation, fees, etc. That's why the safest investment option is a self-directed IRA. These accounts give you the maximum amount of investment options, which means you can even invest in alternative investment vehicles such as CARL's quantitative hedge funds with 15%+ targeted returns at a minimum investment of $20,000. And with the built-in risk controls of CARL's quants, you can freely make significant investments while keeping the risk you're exposed to within acceptable levels.

You can set up your SDIRA as either a traditional or Roth account and start investing with pre-tax or after-tax money, depending on your IRA choice. With sophisticated quantitative hedge funds, it's possible to grow your retirement fund to the point where taxes will no longer feel like an undue burden, thanks to the earnings you gain from actively investing your money. Find out all about CARL's SDIRAs and quant strategies and start building your future today.

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Introducing CARL Self Directed IRA

The CARL Self Directed IRA is now live on the CARL app. Listen to this podcast episode where John Bowens from Equity Trust, our partner in this offering, and Jamie Uppenberg from CARL talk about self-directed IRAs and the benefits of alternative investments like the hedge funds available with CARL.

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