An IRA is a tax-advantaged account that allows you to save money for retirement. Whether you have a traditional or Roth IRA, you don't pay tax on the earnings while the account is growing. The earnings are reinvested and compounded for more growth. When you retire and begin to draw money from the IRA, the amount you pay in taxes depends on the type of IRA, your income and the amount of your withdrawals.
A traditional IRA is funded with pre-tax dollars. You do not any taxes on the contributions or the interest they earn until you begin taking withdrawals during retirement. With a traditional IRA, each withdrawal is taxed as ordinary income. For example, if you are in the 15 percent tax bracket and you take a withdrawal of $10,000 during the tax year, you will owe $1,500 in federal income tax. If your state has a state income tax, you will pay those taxes as well. .
A Roth IRA is funded with after-tax dollars. The main advantage to a Roth IRA is that no only do your earnings grow tax-free, but when you retire and take withdrawals, you pay no income taxes -- not even on the earnings. Withdrawals are not reported as income on your tax return.
Early Traditional IRA Withdrawals
The IRS charges a penalty for taking early distributions. If you withdraw funds from a traditional IRA before reaching age 59 1/2, you are typically required to pay an additional 10 percent penalty on the distribution amount, in addition to the income taxes. Under certain circumstances, the penalty portion of the tax may be waived. For example, you can take penalty-free distributions to pay unreimbursed medical expenses that exceed 7.5 percent of your adjusted gross income. Higher education expenses for you, your spouse, your children or grandchildren also qualify as a special circumstance that allows you to withdraw money from your IRA without facing the early withdrawal fee.
Early Roth IRA Withdrawals
You can withdraw your original contributions from a Roth IRA at any time without penalty, because you have already paid income tax on them. However, early withdrawals of any of your earnings are subject to the IRS 10 percent tax; in addition, income taxes are assessed on the earnings. Along with the age requirement of 59 1/2, the Roth IRA must be established for at least five years before you can withdraw earnings without penalty. Certain withdrawals of the contributions and earnings are allowed without penalty for certain expenses, however, including the purchase of a first home or college education costs.