If you contribute to a traditional IRA you can typically write that contribution off when you file your federal income tax return. All of the investments in your IRA are allowed to grow tax-deferred. But there is no free lunch when it comes to taxes on your traditional IRA. Any withdrawals you make from your traditional IRA are taxed as ordinary income.
The Internal Revenue Service puts few limitations on the types of investments you can buy with money in your traditional IRA. Other than life insurance and collectibles, you can use that money to purchase almost any kind of investment, including interest-bearing financial products such as bank certificates of deposit or tax-exempt municipal bonds. Regardless of how the investments in your traditional IRA grow, whether from interest income, dividends or capital gains, that growth is not subject to current taxation as long as those funds remain inside your IRA.
Tax-Deferred Vs. Tax-Exempt
All withdrawals from your traditional IRA are taxed as ordinary income, regardless of how those funds got into your IRA. That includes any portion of the account that was part of your original contribution, as well as any growth that occurred inside your traditional IRA. Since all withdrawals are taxed as ordinary income, you will lose any tax advantages you might have received from long-term capital gains, or tax-exempt interest on municipal bond investments held in your traditional IRA.
All of the money in your traditional IRA belongs to you. You can withdraw funds from your account anytime you wish, and you must start taking distributions once you reach age 70 1/2. Any money you withdraw will be taxed as ordinary income. If you take money out of your account before you reach age 59 1/2 those funds will also be subject to a 10-percent early withdrawal penalty.
Roth Vs. Traditional
There is no option for tax-exempt withdrawals from your traditional IRA, even if the interest earned on a financial product held in your IRA is tax-exempt. This is in contrast to qualified withdrawals from a Roth IRA, which are exempt from federal income taxes. To qualify for tax exemption, you must have held a Roth IRA for at least five years and met one additional qualifier, such as being at least 59 1/2 years old or being disabled.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.