Contributing money to an individual retirement account can result in owning less income tax in the long run, but you can't avoid income taxes altogether. The tax rate on IRA distributions depends on your age and income tax rate when you access your money and the type of IRA you open. With traditional IRAs you pay income tax at the time of the early withdrawal, but you might not have to pay income tax on early Roth IRA withdrawals.
IRA Withdrawal Basics
With traditional IRAs, you pay income tax on withdrawals in the year you make them. The tax rate on these withdrawals is based on your income tax bracket in the year you make the withdrawal. With a Roth IRA, you have already paid income tax on the contributions you made, so you don't pay income taxes again when you withdraw it even if you withdraw it early. You do, however, pay income taxes on withdrawals of investment gains from Roth IRAs if you withdraw any of these earnings before the age of 59 1/2.
Early Withdrawal Penalty
IRA withdrawals made before the age of 59 1/2 are considered early distributions. For traditional IRAs, in addition to paying regular income tax on your withdrawal, you must also pay a 10 percent early withdrawal penalty. Just as you don't pay income tax on withdrawals of Roth IRA contributions, you don't pay the 10 percent early withdrawal penalty, either. You do, however, pay the 10 percent penalty on early withdrawals of Roth IRA investment gains.
You can take funds out of an IRA early without paying the early withdrawal penalty in a few special cases. According to the IRS, a distribution may be exempt from the early withdrawal penalty if you are disabled, have inherited the IRA from someone else, have medical expenses that exceed 7.5 percent of your adjusted gross income, or took distributions that were less than the cost of your medical insurance. You can also take up to $10,000 out of an IRA to buy or build a first home without incurring the early withdrawal penalty.
Large IRA Withdrawals
For traditional IRA holders, large withdrawals can result in owing more income tax than taking smaller withdrawals over the course of a several years. Since traditional IRA withdrawals are included in normal taxable income, a substantial IRA withdrawal could bump you up to a higher income tax bracket in the year of withdrawal, resulting in a bigger tax bite than you were expecting.
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.