The purpose of an individual retirement account is to encourage you to save for your later years. Congress therefore created carrots and sticks to help you stay on track. The carrot is a tax deduction on contributions and tax-deferred growth of investments. The stick is additional tax on early withdrawals.
A conduit IRA is identical to a traditional IRA, except that it originates from a rollover from an employer’s qualified plan. You might want to keep only rolled-over funds in a conduit IRA if you plan to roll the money to a different employer plan. Some employer plans allow you to roll in money only if it stems from other employer plans. By keeping your plan rollovers segregated in a conduit IRA, you’ll avoid trouble rolling into the new employer plan. You can keep your other IRA money in a separate traditional or Roth IRA because the Internal Revenue Service doesn’t limit the number of IRAs you can own.
You must pay taxes on all withdrawals from a traditional IRA. You might owe an additional 10 percent tax on money you siphon off before reaching age 59 1/2. It doesn’t matter whether the withdrawn money originated from a contribution, a rollover or earnings -- the effect is the same. However, the IRS exempts early withdrawals you take for certain reasons listed in the next section. Also, you don’t pay taxes or penalties on the portion of any withdrawal that represents money already taxed. This can occur if you make nondeductible contributions.
You avoid the additional tax on early withdrawals if you are totally and permanently disabled or if you’re the beneficiary of a deceased IRA owner. Exemptions are available for unreimbursed medical expenses exceeding 10 percent of your adjusted gross income, for the cost of medical insurance if you are unemployed or if you use the money for qualified education expenses. You can also get an exemption for part of the cost of buying or building your first home, for money used to pay an IRS levy on your IRA or if you are a qualified military reservist.
You can withdraw nondeductible contributions from your conduit IRA tax-free. These are contributions on which you were not allowed to take a deduction -- you’ve already paid the income tax on this money. This situation can arise on contributions you make in years during which you or your spouse are covered by an employer’s qualified plan and your gross income exceeds limits set by the IRS. The income limits change from year to year. You cannot simply withdraw just the nondeductible contributions from your IRA. Instead, you must prorate the nondeductible contributions as part of any withdrawal.
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