I am 60 years old and retired. I have a question. I find that I need to withdrawal money each year from my IRA to pay taxes of the money that I with-drawled last year to pay my taxes. I believe that I am paying taxes on money I with-drawled to pay taxes the year before. This is a viscous cycle. that go on year after year. Am I doing something wrong? or is this really how it works. I need to withdrawal more money again this year to pay for the money I withdrew last year to pay my taxes. Seems like a ripoff. Any help or thoughts would be very much appreciated. Thank You..
Yes, that's how it works. Money that you take out of your IRA is generally money on which you have not yet paid taxes, so that money is subject to taxation when you take it out. Certainly your tax rate is not 100%, so not all of the money you take out is going to taxes.
You must think of a tax-deferred retirement account as being partially your money and partially the government's money in proportion to your marginal tax rate, so when you take money out the government gets their proportional share. By incurring a large balance due that must be paid the following year you are simply keeping the government's share a bit longer than if you had given it to the government in the same year as the distribution.
To avoid having a large balance due to pay the following year you could have taxes withheld (10% or more) from the IRA distribution, reducing the amount that you would need to take out the next year. Depending on you tax situation you might find it beneficial to take out more in one year that you actually need for that year and less the next year, such as when the taxable amount of Social Security income depends on your AGI.
No, you are not doing anything wrong. When you withdraw money from a retirement account you are going to be taxed on that amount as income. You either withdraw more than you need to live on and save the remaining amount to pay your taxes or you withdraw the amount to pay your taxes once you have put together the information for your tax return.
For example say you with draw $50,000 to live on, assuming this is your only income and you are Single and taking the Standard Deduction, you taxable income is $38,000. The amount of tax you owe on $38,000 is $4,345. Now the challenge is if you take out another $5,000 for the taxes you also owe tax on that additional amount you took out. Since you have already reduced your income by the Standard Deduction, the additional amount you take out is going to be taxed at 22% for an additional tax of $1100.
So yes it does become a round robin.