Individual retirement accounts can help your retirement savings grow more rapidly since you don't have to pay income tax on your earnings within the account. Unfortunately, most distributions from an IRA are taxable. If you take money out of your IRA before you retire, you may also owe penalty taxes, in addition to federal and state income taxes. A Roth IRA is a special type of IRA that can help you avoid income tax on distributions.
Any money you take out of your traditional IRA must be included in your ordinary income for the year. For income tax purposes, IRA distributions are treated the same as your wages or salary. These distributions are taxable because you received a tax deduction when you contributed money to the account, and nothing in the account has ever been taxed. One of the downsides of this tax policy is that even your capital gains, such as your profits from selling stock, are taxed as ordinary income when you withdraw them from an IRA. If your capital gain was in a non-IRA account, it would usually be taxed at a lower rate.
If you live in one of the 41 states that have their own income tax, you'll have to pay state tax on your IRA withdrawal as well. Since an IRA distribution is included in your taxable income for the year, it will carry over to your state taxes in your adjusted gross income. Unless you are a resident of Nevada, Florida, Texas, Washington, Alaska, Tennessee, New Hampshire, South Dakota or Wyoming, you can't avoid state income tax on your withdrawal from a traditional IRA.
Taking money out of your IRA prematurely can cost you penalties in addition to taxes. The IRS assesses a 10 percent penalty tax on any IRA withdrawals taken before age 59 1/2. Any year you take an IRA withdrawal, your financial services company will send you a 1099-R documenting your withdrawal for your taxes. If you took your money out prematurely, box 7 will list the distribution code for a premature distribution. You'll have to report the distribution on line 58 of your Form 1040 when you file your taxes, and you may also have to complete Form 5239 depending on your individual tax situation.
As long as you make a "qualified distribution" from a Roth IRA, you won't have to worry about federal or state income taxes on your distribution. If you have held your money in the Roth for at least five years, and you take your distribution after age 59 1/2, you won't have to pay anything on the withdrawal. Other exceptions include if you become disabled, die or use up to $10,000 of a Roth distribution for the first-time purchase of a home. Roth IRAs are granted this exemption because you don't get a tax deduction when you make a contribution.
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