An invention of Congress, Individual Retirement Accounts (IRAs) were part of the 1974 Employee Retirement Income Security Act (ERISA). Lawmakers intended the accounts as tax-efficient savings vehicles for workers not covered by workplace retirement plans. While the focus remains on retirement, IRAs have become more versatile investments over the years. The type of account you have, when you access your money and what you use it for determine the tax consequences you could face.
Two main types of IRAs exist -- traditional and Roth IRAs. The 1974 act established the traditional IRA. As IRS Publication 590 explains, you can deduct the money you contribute to this type of account from your taxable income, up to an annual limit. The Taxpayer Relief Act of 1997 ushered in the Roth IRA, which does not allow for the same type of up-front tax deduction.
Because you receive the instant tax benefit of the aforementioned deduction, the IRS taxes all withdrawals you take from a traditional IRA, regardless of age, timing or circumstance. The tax benefit of a Roth IRA comes when you access your money. No matter when you take a distribution (i.e. withdraw funds), original contributions come out tax-free. Generally, the IRS does not tax the earnings on original Roth contributions, as long as they occur after you turn age 59 1/2 and come out of accounts that are at least five years old.
The IRS levies a 10-percent tax penalty on non-qualified distributions from all types of IRAs. Generally, if you take money out of an IRA prior to turning age 59 1/2, the IRS charges this penalty in addition to any other regular taxes due. Remember, however, that the ten-percent penalty does not apply to original contributions that you remove from a Roth IRA.
Tax Consequence Examples
Consider traditional and Roth accounts, each with $10,000 worth of original contributions that have increased in value to $15,000. Assume a $12,000 withdrawal from these accounts. The IRS charges regular income tax on the entire $12,000 distribution, regardless of age or circumstance. If the distribution comes prior to age 59 1/2, the IRS, in most cases, tacks an additional ten-percent penalty onto the $12,000. If a Roth owner withdraws $12,000 after turning 59 1/2 and holding her account for at least five years, the entire amount comes out tax- and penalty-free. If a Roth owner removes the $12,000 prior to turning 59 1/2 or without satisfying the five-year rule, the IRS charges regular income tax as well as the 10-percent penalty on the last $2,000; however, the first $10,000, which consisted of original contributions, comes out tax- and penalty-free.