The federal government allows taxpayers to set up Individual Retirement Accounts (IRAs) and take advantage of certain tax benefits. Two common types of IRAs are traditional and Roth IRAs. The traditional IRA allows you to deduct some of your contributions and pay the income tax when you make withdrawals. In contrast, Roth IRA contributions are nondeductible, but you can make tax-free withdrawals. However, the government imposes significant restrictions on your ability to make withdrawals until certain milestones occur.
Early Withdrawal Penalties
Since the government provides you with tax deductions when making contributions to a traditional IRA, it provides incentive for you to refrain from withdrawing the funds before retirement. While the government can't stop you from making a withdrawal, if you take one before you reach the age of 59 1/2, the IRS will impose a 10 percent penalty on top of the income tax you owe on any withdrawal from the IRA.
Early Withdrawal Exceptions
Under certain circumstances, the government will allow you to make withdrawals from your traditional IRA account before you reach 59 1/2 without imposing the penalty. The exceptions include a disability that prevents you from engaging in any substantial gainful activity, and incurring medical expenses that exceed 7 1/2 percent of your adjusted gross income while you are receiving unemployment benefits for at least 12 consecutive weeks, and are paying health insurance premiums. There is also an exception in some cases when you need the funds to enroll in school or purchase your first home.
Mandatory IRA Withdrawals
There are times when the government requires you to begin making withdrawals from your traditional IRA account. The reason for this is that the government wants to ensure that it actually collects income tax on the funds within the account. Therefore, once you reach 70 1/2 years of age, you must begin making withdrawals by April of the following year. The IRS will use a life-expectancy calculation to determine the minimum withdrawals you must make each year after this time. If you fail to withdraw the minimum, the IRS can impose a 50 percent penalty on the difference between the amount you withdraw and the minimum required withdrawal.
Roth IRA Withdrawals
Instead of saving taxes on your contributions with a deduction, you recognize the tax savings through tax-free withdrawals with a Roth IRA. The IRS requires that you wait until you reach the age of 59 1/2 and have owned the account for at least five years to receive the entire withdrawal tax-free. However, unlike the traditional IRA, you can make withdrawals of your contributions without any tax implications. But if you withdraw amounts in excess of your total contributions, that excess is subject to income tax and penalties. Similar exceptions that apply to traditional IRAs also apply to Roth IRAs.
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