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Ask the Expert: What are the rules for taxes on an IRA?

I'm confused about the taxation of IRAs. We already paid taxes on the money we invested in the IRA; we were just deferring taxes on the interest it earned. We were never told you’ll be taxed on the full withdrawal. Also, when did they change the rules so that you can only have a certain portion of your IRA when it's time to withdraw it? We weren’t told that there would be a limit on what you can withdraw.

There isn’t a limit on individual retirement account withdrawals. There's a required minimum annual distribution after you turn 72. There's no maximum limit.

As to taxes, you're confusing two types of IRA: the deductible IRA and the nondeductible IRA.

With a deductible IRA, you don’t pay current taxes on contributions. You defer taxes both on contributions and on their earnings. You're therefore taxed on the entire amount you withdraw from a deductible IRA.

With a nondeductible IRA, you pay current taxes on contributions; therefore only the IRA’s earnings are taxed when withdrawn. If you made $30,000 in contributions to a nondeductible IRA, for example, that $30,000 is tax-free when you withdraw it. But you can’t withdraw it in a lump sum. Each withdrawal includes some taxable money.

"Making nondeductible IRA contributions is like adding cream to a cup of coffee. You can't take it out separately," says Ed Slott, a Rockville Centre tax accountant. "There's going to be a little cream in every sip you take."

To determine how much of each distribution is taxable, divide your after-tax contributions by the IRA's current market value. If you contributed $30,000 and the IRA is now worth $100,000, 30% of each withdrawal will be tax-free.

The bottom line

There’s more than one kind of individual retirement account, and each has its own rules.

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