Individual retirement accounts offer tax advantages that can reduce the total amount of tax you pay on retirement savings, but they don't let you avoid income taxes entirely. The tax treatment of IRA distributions or withdrawals depends on the type of IRA you own. Traditional IRAs require you to pay income taxes at the time of withdrawal, while you can generally withdraw Roth IRA funds tax free.
Traditional IRAs are similar to 401(k) plans in that they delay income taxes on savings until retirement. With a traditional IRA, contributions are fully tax deductible if you aren't covered by a retirement plan at work or if you make less than $58,000 as a single taxpayer or $92,000 as joint filer. Taxes on investment gains within an IRA are tax deferred until the time of withdrawal. When you take money out of a traditional IRA, you treat the distributions as normal income that is subject to income tax.
Contributions made to a Roth IRA are not tax deductible, which means you have to fund a Roth with after-tax income. On the other hand, you don't have to pay any tax on Roth IRA withdrawals as long as you take money out after age 59 1/2 and you wait at least 5 years after opening the account to access your funds. In essence, a Roth IRA lets you pay income taxes upfront to avoid taxation at the time of withdrawal.
If you take money out of a traditional IRA before the age of 59 1/2, the withdrawal is subject to a 10 percent early withdrawal penalty in addition to normal income taxes. You can withdraw contributions you made to a Roth IRA at any time without penalty, but if you distribute investment gains earned in a Roth IRA before the age of 59 1/2, the gains are subject to the 10 percent penalty and income tax. The early withdrawal penalty can be waived in certain cases, such as if you are disabled, pay more than 7.5 percent of your adjusted gross income in medical expenses or use the money to buy or build a first home.
Traditional IRAs are subject to "required minimum distributions" that force you to withdraw funds starting at age 70 1/2. If you don't make a required withdrawal, the amount you fail to withdraw faces a tax penalty of 50 percent. Roth IRAs are not subject to required minimum distributions, and you can continue contributing to a Roth IRA after age 70 1/2.