Traditional IRA accounts and 401(k) plans allow you to save money and defer taxes on your retirement savings, but other types of retirement accounts allow you to withdraw money tax-free at retirement. These plans with nontaxable distributions make particular sense for people who expect to be in a higher tax-bracket at retirement. Even with uncertainty about what level of income taxes you will pay at retirement, many investors see value in having some of their retirement funds in nontaxable accounts.
All Roth IRA distributions taken at retirement are nontaxable -- both your contributions and the investment gains on the account. Also, you can withdraw Roth IRA contributions at any time without incurring income taxes. Roth earnings, or investment gains, are generally not taxable if you are at least 59 1/2 years old and the account has been open at least five years.
While traditional 401(k) distributions are taxable, some employers offer a Roth 401(k). With this type of account, you can take tax-free withdrawals of your after-tax contributions and the investment gains on these contributions. Matching contributions from your employer and the gains on these contributions will be taxed when you withdraw them.
Nondeductible IRA Contributions
If you are not eligible to make deductible IRA contributions, you may make nondeductible IRA contributions. When you take a disbursement from your IRA of the nondeductible contributions, this money is nontaxable. Investment gains on these nondeductible contributions are still taxable as income.
Once a year, you can take a disbursement from an IRA, redeposit the funds into the same account or another IRA of the same type within 60 days and not owe taxes or penalties on the money. The receiving account, if different, is affected by the same one-year waiting period.
While technically not a distribution, any trustee-to-trustee transfer of money between two different IRA accounts is nontaxable. An example of a trustee-to-trustee transfer is if you are moving an account to a different mutual fund company. You are not restricted by any waiting periods for these transfers.
Early Withdrawal Penalty
If you withdraw money from a traditional IRA or 401(k) before you are 59 1/2, you will owe a 10 percent tax penalty in addition to any taxes on the amount you withdraw. For a Roth account, no penalty is due on any contributions you withdraw. You generally will not owe a penalty on investment gains you withdraw, as long as the account has been open at least five years.