There are two primary types of individual retirement accounts; traditional IRAs and Roth IRAs. Each type of account offers significant tax benefits, but there are differences between these accounts as well. One of the most prominent differences is how contributions and withdrawals are taxed. Unlike contributions to a traditional IRA, which are made with pre-tax dollars, contributions to Roth IRAs are made with after-tax dollars. This pays an important role in how withdrawals are taxed.
Funds contributed to either a traditional or Roth individual retirement account may be invested in a wide variety of income producing products, ranging from very conservative bank certificates of deposit to higher risk investments such as stocks, bonds, mutual funds or real estate investment trusts. Any income produced within these IRA accounts is allowed to accrue on a tax deferred basis, which means this income is not subject to current income taxation.
Roth IRAs are funded with after-tax dollars. Since you have already paid income taxes on these funds, you may withdraw them at any time for any reason without generating a taxable event. There are no tax consequences to making a principal withdrawal from an after-tax tax deferred account. You do not have to report this type of withdrawal to the Internal Revenue Service.
Any income produced from funds contributed into an after-tax Roth IRA grows on a tax deferred basis until it is withdrawn. These earnings must remain in the tax deferred account for at least five years to avoid any tax penalties. You can start taking qualified withdrawals of earnings that have been in your after-tax tax deferred account for at least five years once you reach 59 1/2 years of age. Qualified withdrawals of either principal or earnings are free from federal income taxes and do not need to be reported when you file your federal income tax return.
Funds in an after-tax tax deferred account, such as a Roth IRA, always belong to you and you may withdraw them at any time for any reason. There are significant tax consequences for withdrawing the earnings portion of your account prior to reaching 59 1/2 years of age and the earnings being in the account for at least five years. These withdrawals are non-qualified. The earnings portion of a non-qualified withdrawal will be taxed at your current federal income tax rate, and the Internal Revenue Service will charge you an additional tax penalty of 10 percent of the amount of non-qualified earnings withdrawn. The tax penalty may be waived under certain hardship conditions, but federal income taxes must be paid on all non-qualified withdrawals.