Contributing to a tax-deferred account, such as an individual retirement account (IRA), is a good way to shield some of your income from the tax man, but sooner or later you will have to pay the piper. When you pay taxes and how much you pay depends on such factors as what type of IRA you have, whether or not your withdrawals are qualified and if there are any extenuating circumstances.
You get to deduct your contributions to your traditional IRA when you file your federal income tax return, and all of the investments in your IRA grow tax-deferred, regardless of how the growth occurs. There is a trade-off for those tax benefits. All withdrawals from a traditional IRA are taxed as ordinary income at your then-current tax rate in the year you take the withdrawal.
Penalties and Exceptions
If you withdraw funds from your traditional IRA before you reach age 59 1/2 years, the IRS will tack on an early withdrawal penalty equal to 10 percent of the amount withdrawn, in addition to ordinary income taxes. The IRS will waive the early withdrawal penalty if you take the withdrawal after becoming disabled, if you're using the money to buy or build a first home, to pay for excessive medical expenses or qualified higher education expenses, or to pay for health insurance after you lost your job.
While you don't get to take a tax deduction for contributions to a Roth IRA, your investments in your Roth account grow tax-deferred. Since you've already paid taxes on your contributions, you can with draw those funds anytime you want without paying any additional income taxes. You don't even have to report the withdrawal to the IRS. Once your account becomes qualified all of your withdrawals are completely free from federal income taxes. Your account becomes qualified after you've had a Roth for at least five years and meet one additional requirement, such as being 59 1/2 years old, being disabled, using the money to buy a first home or in the event of your death.
Non-qualified withdrawals of the earnings portion of your Roth account are taxed as ordinary income at your then-current income tax rate, plus the 10 percent early distribution tax. If you haven't had a Roth account for at least five years, the earnings portion will always be taxed as ordinary income, but you might be able to avoid the 10 percent penalty under certain circumstances. For example, the IRS waives the early withdrawal penalty if you are at least 59 1/2, are disabled, use the money to pay for non-reimbursed medical expenses or health insurance premiums, to pay for higher education expenses or to buy a first home.
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.