While individual retirement accounts offer a number of tax advantages, there's no such thing as a free lunch. You either have to pay taxes on the money as it goes into your IRA or you have to pay when it comes out. Only qualified withdrawals of the earnings portion of a Roth IRA are completely free from federal income taxes.
There are two types of individual retirement accounts: traditional and Roth IRAs. The primary difference between the two involves when you pay the taxes. Contributions to a traditional IRA are made with pre-tax dollars, while contributions to a Roth are made with after-tax dollars. In other words, you can take a tax deduction for your contributions to a traditional IRA, but you can't deduct Roth contributions. All of the investments in a traditional or Roth IRA grow tax-deferred inside the account.
Traditional IRA Withdrawals
All of the money in your traditional IRA belongs to you, and you can withdraw funds whenever you wish. All withdrawals from your traditional IRA are taxed as ordinary income at your regular income tax rate. If you withdraw money before you reach age 59 1/2, you may also have to pay an early withdrawal penalty equal to 10 percent of the amount you take out. In certain situations, such as if you become disabled, you may be able to avoid paying the early withdrawal penalty. However, you can't avoid paying ordinary income taxes on traditional IRA withdrawals.
Roth Return of Contributions
You have to pay taxes on the money you use to contribute to a Roth IRA. Therefore, you can withdraw an amount from your Roth that is equal to the total amount of your contributions without paying additional taxes on those funds. While this is a benefit that is not available with a traditional IRA, it is not a completely tax-free transaction, since you've paid taxes on these funds in advance.
Roth Qualified Withdrawals
If you take the earnings portion of your Roth IRA out before they become qualified, these funds will be taxed as ordinary income and may be subject to the 10 percent early withdrawal penalty. The only time you can withdraw the earnings from your Roth IRA tax-free is after the earnings become qualified. To become qualified, you must have had the account at least five years and meet one of the additional qualifications from the Internal Revenue Service. These include reaching age 59 1/2, becoming disabled or using the funds to pay for a first home.
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.