The IRA, or individual retirement account, features tax advantages that encourage saving for your later years. The Internal Revenue Service allows you to deduct contributions to a traditional IRA but takes its share as ordinary income tax when you withdraw money from the account. Roth IRA contributions are not deductible, but distributions at retirement age are tax-free. WIth either type of account, early withdrawals may trigger a penalty.
Because IRA money is intended for retirement use, distributions taken before you reach age 59 1/2 are subject, with few exceptions, to a 10 percent penalty tax. In addition, you must pay ordinary income tax on any traditional IRA withdrawal. At 2012 personal income tax rates, an early withdrawal might be reduced by as much as 48 percent, that is 38 percent (the top tax rate) plus the 10 percent penalty. You pay the tax and penalty when you file your income taxes for the year.
Roth IRA owners can withdraw contributions at any time. However, if you withdraw earnings within five years of first contributing to the Roth and before you reach age 59 1/2, the early withdrawal rules that apply to the traditional IRA also apply to Roth earnings. That means you'll pay income tax plus a 10 percent penalty. If you take earnings from a Roth after age 59 1/2 but before the account has been open for five years, you pay only income tax on the funds. In any case, you pay the taxes and/or penalties at tax-filing time. To be clear, if your Roth has been open for five years and you take out earnings after age 59 1/2, you will owe neither tax nor penalty.
Traditional IRA owners have to begin taking distributions at age 70 1/2. These required minimum distributions are calculated by dividing the end-of-year account balance by a figure on an IRS life-expectancy table. You'll pay income tax on this amount each year when you file your return. If you fail to withdraw the minimum in a given year, the IRS levies a 50 percent excise tax on the amount that should have been withdrawn. For example, your RMD for 2012 is $500. By some error or oversight, you take only a $400 distribution. You have to pay a $50 excise tax, which is 50 percent of the $100 of the RMD you failed to withdraw, at tax time.
You can avoid the early withdrawal penalty if you use the money (up to $10,000 in your lifetime) to fund the purchase or construction of a home. Paying for higher education expenses for yourself or your family is another way to avoid the penalty. If your medical expenses amount to more than 7.5 percent of your adjusted gross income for the year, you can use IRA funds to pay them, without incurring a penalty. You can also escape the penalty if you become totally and permanently disabled.