If you have earned income then you can invest some of your earnings into either a traditional individual retirement account or a Roth IRA. Your funds grow tax deferred in both of these IRAs but there are different tax implications when you make withdrawals from a Roth as opposed to a traditional IRA.
You can liquidate a Roth or a traditional IRA and use the account proceeds as supplemental income. The taxes that you pay on your withdrawals depend on whether you make a qualified or non-qualified withdrawal. You make a qualified withdrawal from a Roth if you are aged 59 1/2 or over as long as you have kept the money in the Roth for a minimum of five years. On a traditional IRA you also have to wait until you reach age 59 1/2 to make penalty-free withdrawals but you do not have to contend with the five-year limitation on withdrawals. Other types of withdrawals from both account types are non-qualified although exceptions are made for withdrawals made to cover certain expenses such as medical costs or college tuition.
If you make a qualified withdrawal from a traditional IRA, the funds you receive are added to your taxable income for the year. This means you have to pay federal income tax on the money as well as state income tax if your state assesses such a tax. You normally fund a traditional IRA with pre-tax money but you can also make non-deductible contributions to these accounts. Nevertheless, you pay income tax on withdrawals regardless of whether you made your contributions on a pre-tax or an after-tax basis. Roth contributions are post-tax, but qualified withdrawals are tax-free -- which means you do not even have to pay tax on your account earnings.
On a traditional IRA, you pay the same taxes on non-qualified withdrawals that you pay on qualified withdrawals. But you also have to pay a federal tax penalty that amounts to 10 percent of the withdrawal amount. You can withdraw your principal from your Roth any time without having to pay any taxes. However, non-qualified withdrawals of earnings are subject to state and federal income tax. You also pay the 10 percent federal tax penalty on your account earnings.
Roth IRAs ultimately provide you with the opportunity to enjoy tax-free income. But Roth contributions are subject to income restrictions. Traditional IRA contributions are also subject to income restrictions, but only if you or your spouse have access to a 401(k) or similar workplace retirement plan. If you are under the age of 50 then you can only contribute up to $5,000 into each account type annually, although that figure rises to $6,000 once you reach age 50. Therefore, due to income restrictions and dollar contribution limits, you may end up making annual contributions to both plans even though only the Roth provides you with the potential for tax-free income.
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