Although you get some great tax breaks when you invest in an individual retirement account (IRA), that doesn't mean you escape the attention of the IRS entirely. The rules for taxes on IRA withdrawals vary depending on whether you have a traditional or Roth IRA. Employer-provided Simplified Employee Pension (SEP) and Savings Incentive Match Plan (SIMPLE) IRAs follow traditional IRA withdrawal rules.
You get to deduct the money you put into a traditional IRA when you file your tax return. Those contributions, plus all investment earnings, are not subject to income taxes until they are withdrawn. When you take money from a traditional IRA after you reach age 59 1/2, it is taxed as ordinary income in the year withdrawn. A point to remember: even earnings that normally qualify for favorable capital gains tax rates or as tax exempt earnings will be subject to ordinary income taxes.
Mandatory Minimum Distributions
Because all of the money in a traditional IRA is normally taxable when distributed to you, the IRS wants to make sure you eventually take it out. Therefore, you have to stop contributing to the IRA when you turn 70 1/2 and begin mandatory minimum withdrawals. The amount you must take out each year is calculated to empty the account within your expected lifetime. If you don't take out the minimum, the undistributed amount is subject not only to ordinary income taxes, but also to a 50 percent excise tax.
There's no tax deduction for contributing to a Roth IRA. Instead, all of the money in a Roth IRA is exempt from income taxes when withdrawn once two conditions are satisfied. The Roth IRA must be at least five calendar years old and you must be 59 1/2 years old. Funds rolled over into a Roth IRA must remain in the account for five years even when the other money can be withdrawn. Because there is no tax liability, the IRS doesn't care if you take the money out or not, so there are no mandatory minimum distributions. You can leave the money in the account as long as you wish and make contributions at any age.
If you choose to withdraw money from a traditional or Roth IRA early, the IRS normally imposes a 10 percent penalty tax in addition to levying ordinary taxes on the withdrawn funds. However, if the money is withdrawn for certain reasons, the penalty tax is waived. You will still have to pay ordinary income taxes. Allowed reasons include the purchase of a first home or the payment of qualified higher education costs, paying an IRS levy and if you become permanently disabled. You can also withdraw funds early without penalty to help pay unreimbursed medical bills or to pay health insurance premiums while you are unemployed. You may also arrange substantially equal annual payments before you reach age 59 1/2. This option, once elected, may not be changed and must be for a period of at least five years or until you reach age 59 1/2, whichever is longer.