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What Are the Tax Implications of IRAs?

It depends on the way the IRA pays out.

Question: I don’t understand the tax implications of owning investments in an IRA. When I withdraw the money, do I have to declare it as regular income? And will it be taxed differently if the withdrawal is a dividend or capital gain?

Ric: Some investments generate interest, others dividends and still others capital gains, and these often get different treatment by the tax code.

However, when the asset is in an IRA, the IRA rules trump (usually, anyway — there are some exceptions, such as with MLPs). And the rules vary depending on the type of IRA you have.

If you have a deductible IRA, you don’t pay taxes on the interest, dividends or capital gains until you withdraw money from the account. You’ll owe income taxes on the amount withdrawn — regardless of whether the money is principal, interest, dividends or capital gains.

If the account is a nondeductible IRA, withdrawals of principal are not taxed — but you have to withdraw principal and nonprincipal in a pro rata fashion.

If the account is a Roth IRA, withdrawals are tax-free if the money has been in the account for at least five years and you are over age 59½.

Even though it’s exciting to be able to have money grow for decades without taxation, the news isn’t always good. Here’s why: Outside an IRA, you pay taxes on profits when you sell an asset. And if you die while owning it, the asset passes to heirs, and they don’t have to pay any taxes on the built-up gain. This is called a “step-up in basis.”

For example, say you buy an asset for $20,000. That’s your cost basis. Say it later rises to $50,000 in value and you die. When your kids sell the asset, they won’t have to pay a capital gains tax on the $30,000 profit — but you would have had to if you had sold the asset during your lifetime.

But if you had held that asset in an IRA, the kids would owe taxes on the full $50,000 value!

So the good news about putting assets into an IRA is that you simplify the tax record-keeping and you delay the tax bill. The bad news is that taxes will eventually be paid — by your heirs, if not you — and at higher tax rates. And they will not enjoy the step-up in basis otherwise available.

So which is better: to invest in a retirement account/IRA or in a taxable account? The answer depends on your situation and the asset involved — and that’s why you should let a financial advisor help figure it all out for you.

This material was prepared for informational and/or educational purposes only. Neither Financial Engines Advisors L.L.C (also referred to as Edelman Financial Engines) nor its affiliates offer tax or legal advice. Be sure to consult with a qualified tax or legal professional regarding the best options for your particular circumstances.

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