In many ways, a traditional individual retirement account is the best of both worlds when it comes to saving for retirement. When you put money in, you can usually take a tax deduction, and while your money remains in the account, you don't have to pay taxes on your income. Sooner or later, however, you'll have to pay the piper. Money you take out of a traditional IRA is usually hit with taxes, and sometimes penalties.
Tapping Your IRA
The Internal Revenue Service usually slaps taxes on traditional IRA withdrawals because that money has never been taxed. The bad news from a tax perspective is that the IRS considers everything you take out to be income, the same as your wages or salary, rather than capital gains, which don't get taxed as highly. You'll owe federal income tax on the money you withdraw, along with state income taxes, if applicable. You can avoid taxes on any after-tax contributions you may have made to your traditional IRA, but those are relatively rare, and you'd still owe income tax on your earnings.
Rolling It Over
One way to avoid IRS taxes is to roll over your IRA distribution, rather than simply putting it in your pocket. A rollover occurs when you move money from an IRA to another retirement plan such as a 401(k) or another IRA. As long as you complete the rollover within 60 days, you typically won't face any taxes on the transfer. One exception would be if you roll your money over to a Roth IRA, which is an after-tax account. In this case, you'll owe taxes just as if you took a cash distribution of the money.
Getting Out Early
If you run afoul of IRS rules, you might trigger penalties on top of your taxes. An early withdrawal, or one taken before age 59 1/2, runs counter to the purpose of an IRA, which is meant for retirement savings. As a result, the IRS will hit you with a 10 percent penalty if you take money out before you're 59 1/2. You can avoid paying the penalty for some qualifying reasons, such as if you become disabled or need the money for certain medical and educational expenses. Another way to avoid the penalty is if you begin taking yearly payments that are basically equal in size for the rest of your life.
Paying the Price
Once you reach age 70 1/2, you may face another penalty in the form of a whopping 50 percent excise tax. The IRS requires you to take money out of your IRA every year after you turn 70 1/2. If you don't take enough out, as determined by IRS tables, you are considered to have taken insufficient distributions, also known as excess accumulations. The IRS will penalize you half of the amount that you should have withdrawn.
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