Individual retirement accounts offer a number of tax benefits that make them attractive savings vehicles for retirement. For example, you may be able to take a tax deduction on your contributions to an IRA, and you won't have to pay any tax on your investments while they remain in the account. When you take a withdrawal, you'll usually have to pay taxes, unless you take a qualified distribution from a Roth IRA.
Although you can legally contribute after-tax money to a traditional IRA, you're likely to make a deposit to your IRA to take advantage of the tax deduction on your contribution. Since any interest or investment gains you earn within an IRA are also tax-deferred, it means that all of the money you take out of your traditional IRA has never been taxed. As a result, all of your traditional IRA withdrawals will be fully taxable. The IRS considers all IRA distributions to be ordinary income. Even if all the profits in your account are the result of capital gains, you'll still have to pay tax at your ordinary income tax rate.
The Roth IRA takes the model for the traditional IRA and reverses it. Rather than offering a tax deduction on contributions and levying a tax on withdrawals, a Roth IRA neither grants a deduction on contributions nor assesses taxes on distributions. As long as you're over 59 1/2 years old and have had your Roth account for at least five years, all the money you take out of your Roth will be tax-free. If you don't meet these criteria for a qualified distribution, you can still take out your Roth contributions at any time without triggering any tax.
If you take money out of your IRA with the intention of moving it to another retirement account, you can avoid taxes on the withdrawal if you complete the transfer in a timely manner. The IRS allows for the tax-free rollover of funds between retirement accounts, such as IRAs or 401(k) plans. An exception is if you roll over money from a pre-tax account, such as a traditional IRA, to an after-tax account, such as a Roth IRA. In this case, the entire amount of your transfer is taxable. If you fail to complete a tax-free rollover within 60 days, the IRS will regard your transfer as a distribution, with applicable taxes assessed.
Additional Taxes & Penalties
Taking money out of an IRA before age 59 1/2 can result in penalties in addition to any tax you may owe. These "early distributions" trigger a 10 percent penalty unless you have a qualifying reason for the withdrawal, such as certain educational or medical costs. Once you reach age 70 1/2, you'll have to take out a required minimum amount every year from your traditional IRA or face a 50 percent penalty on the amount that you were required to take out but didn't.
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