An individual retirement account (IRA) is a method of saving funds for retirement. Since the funds are meant to be left until the account owner retires, there are tax consequences and penalties if the money is removed prematurely. Different types of IRAs are distinguished by certain characteristics.
A Roth IRA is a type of retirement savings account that allows the investor to save after-tax money towards the future. Money that is put into a Roth IRA has already had taxes paid on it, so when it is withdrawn after the account owner reaches retirement age no taxes are due. This applies not only to the amount of money the account owner actually contributed, but to any earnings on the funds as well, which can result in a tremendous tax advantage when the money is disbursed. A Roth IRA grows from a variety of investments and from the interest paid on the account, usually at a fixed rate for the life of the IRA.
Variable IRA Basics
A variable IRA is similar to a traditional fixed-rate IRA, with the important difference that the interest rate can and typically does change. The frequency of the rate adjustment is specified by the bank or other trustee holding the funds; the account owner is provided with this information when he opens the account. The trustee may require that the funds be left in the account for a set period, such as 12 to 60 months, in order to provide the best interest rate. The account is funded with pre-tax dollars, giving the account owner an immediate tax benefit.
Taking money out of an IRA before the account holder is 59 1/2 causes certain tax penalties. If the money is in a Roth IRA, there is no income tax on the money that is withdrawn, but there is a 10 percent penalty that is imposed for early withdrawal. Money taken from a variable IRA before the account owner reaches retirement age will not only have the 10 percent penalty, it will also be added to the account holder’s income for the year and taxes will be due on the full amount. Typically 20 percent of the amount is withheld for taxes in addition to the 10 percent, which even then may not be enough to cover all the taxes that are due. A variable IRA may also incur interest penalties from the bank holding the funds if removed prematurely.
Although variable IRAs may be set up for relatively short periods of time, the funds can be left in place and rolled over for another term so that the account will continue to grow. There is also a period of time after the account matures that is established by the bank, usually a week or less, in which the owner can roll over the funds into another type of retirement account without penalty. If the change is made by a direct transfer of funds, there will not be any withholding, but if the account holder receives the funds and transfers herself into another account, the original funds will have 20 percent withheld for taxes, plus another 10 percent, if applicable. A direct transfer is the best way to avoid this issue.