Retirement might look like it's a long way off, but one thing is certain; it gets closer every day. Regularly setting aside a little money in a tax-advantaged individual retirement arrangement now can pay off big when it comes time to leave the rat race behind. Even though IRAs have specific tax advantages, there are still tax consequences to consider, either before you contribute or when you start taking retirement distributions from your retirement account.
Retirement age is an ambiguous figure. For Social Security purposes, if you were born after 1959 your full retirement age is 67 years. You can retire from U.S. military service after 20 years of active duty, regardless of your age. When it comes to your individual retirement account, the magic age number is 59 1/2. That's the age you can withdraw money from your traditional IRA without incurring a tax penalty and it is the age qualifier for Roth IRA withdrawals.
Traditional IRA Withdrawals
You typically get to take a tax write-off for contributions to your traditional IRA, and all of the investments in your IRA grow tax-deferred. Money you withdraw from your traditional IRA after you reach retirement age is taxed as ordinary income at your then current tax rate. Your IRA custodian will automatically withhold taxes from your traditional IRA distributions, unless you instruct it otherwise, and will provide you with a 1099-R or similar reporting statement detailing your withdrawal. It's your responsibility to report the withdrawal when you file your federal income tax return.
Roth IRA Withdrawals
The IRS has different rules for Roth IRA withdrawals. The earnings portion of your Roth IRA don't become qualified until you've had a Roth account for at least five years and you meet one additional requirement, such as reaching retirement age. Once your Roth IRA earnings are qualified you can take them out without any tax obligation. You don't even have to report qualified withdrawals.
Just because you are retired doesn't mean withdrawals from your individual retirement account are qualified. For example, if you joined the U.S. Army right out of high school when you were 18 years old, you can retire at age 38 after 20 years of service. You could withdraw money from your traditional IRA at that time, but in addition to ordinary income taxes, you would get hit with an additional 10 percent tax penalty.
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.