An Individual Retirement Account, or IRA, is attractive to investors in part because of how the Internal Revenue Service handles the taxes on IRA funds. You still have to pay taxes eventually, but while the money is in the IRA account, it grows tax-free. Several variables determine how much you'll have to pay in tax on your IRA at retirement.
Current Tax Rate
With a Roth IRA, you pay taxes on your income and then use post-tax dollars to make contributions. The IRS doesn't assess taxes on the funds a second time and earnings within a Roth IRA are tax-free. As long as you follow the rules for Roth IRA withdrawals, you generally don't pay any taxes on a Roth IRA at retirement. With a traditional IRA, you make contributions with pre-tax dollars, then the IRS taxes the money as you withdraw it. This means that the amount of tax you'll pay will depend on the income tax rate in effect at the time you withdraw the funds. The fact that you cannot guarantee what the tax rate will be when you take distributions at retirement is one reason why some people prefer to establish Roth IRAs instead of traditional IRAs.
Distribution Amount Variance
The IRS requires you to take a distribution, or withdrawal, at least once a year from a traditional IRA after you reach age 70 1/2. You must do this because an IRA is supposed to fund your retirement -- if you don't use the funds during your retirement, you won't satisfy the purpose of the IRA. Using life expectancy charts, the IRS divides the value of the account by how many years you are expected to live to determine the amount you must take each year as a distribution. Your required distribution thus varies from year to year. So, too, does the resulting tax.
The IRS assesses penalties on early withdrawals. If you have a traditional IRA and take money out of it before you reach age 59 1/2, you'll be charged a 10 percent penalty on the taxable amount of the withdrawal; because traditional IRAs are tax-deferred, this usually means 10 percent of the distribution amount. With a Roth IRA, you usually can take your money out at any time, as the required minimum distributions don't apply with Roths. However, before age 59 1/2, the IRS still will assess the 10 percent penalty if you withdraw any earnings from the Roth IRA or funds you converted from a traditional IRA. This means that you'll be penalized for taking more than you contributed from the Roth IRA. Traditional IRAs have late distribution penalties as well. If you are age 70 1/2 and don't withdraw your required minimum distribution, the penalty is 50 percent of the required minimum distribution remaining. For example, if you were supposed to take out $1,000 and you only took $500, the penalty would be half of the remaining $500, so $250.
Typically, the IRS taxes individuals who have higher incomes at a higher rate than those with low incomes. For example, the tax rate for a single person making up to $8,500 per year was 10 percent in 2011, while a single person making over $379,150 had a rate of 35 percent. Thus, the more income you have, the more you likely will pay in tax on your IRA funds at retirement.
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