The Internal Revenue Service (IRS) does not require you to pay taxes on the funds held inside your individual retirement arrangement (IRA) until you make a withdrawal. Your IRA funds remain tax-sheltered when you roll the money to a new IRA. However, if you actually withdraw some of the money either during or after the rollover, you have to pay income tax and you may also have to pay federal tax penalties.
The federal tax code includes a 60 day rule, which means that you can withdraw money from your IRA or a rollover IRA without having to pay taxes or penalties as long as you reinvest the money into an IRA within the next 60 days. At the time of your withdrawal, your IRA trustee normally withholds 10 percent of your IRA distribution to cover federal tax, but you can instruct the trustee not to withhold any money for federal taxes. In states such as Iowa and Vermont, your trustee may have to withhold some of the distribution to cover state taxes but you eventually recoup that money if you return the funds to the account within the next 60 days.
Ordinarily, your standard income tax rate and penalties will apply to IRA withdrawals, but if you are disabled or 59 1/2 or older, you can withdraw funds without incurring a tax penalty. Withdrawals that do not incur federal tax penalties are known as qualified withdrawals. You can also make a qualified withdrawal of up to $10,000, to access funds that you plan to use towards buying your first home. The IRS treats distributions used to fund some medical costs, medical insurance premiums and higher education costs for you or your family as qualified withdrawals. Finally, you pay no penalties if you withdraw your regular IRA or IRA rollover money in the form of roughly equal payments that are designed to last for your entire lifetime.
Withdrawals that do not meet the IRS' criteria for qualified withdrawals are known as non-qualified withdrawals. You pay a 10 percent federal tax penalty if you make non-qualified withdrawals from your rollover IRA or other tax deferred accounts. Contributions to traditional IRAs and most pension plans are tax-deductible, which means you have to pay the penalty tax and income tax on withdrawals from these plans. You cannot deduct Roth IRA contributions from your taxable income. Consequently, withdrawals of principal from a Roth are not subject to income tax or tax penalties. You do pay taxes and the 10 percent penalties on your earnings when you make a non-qualified withdrawal.
When you rollover funds between IRAs or from a pension plan to an IRA, you actually receive the account proceeds. You can only complete one of these rollovers once within a 12 month period. If you attempt to rollover your funds for a second time within 12 months, then you must accept the distribution as a withdrawal and pay all applicable taxes and penalties. If you organize a trustee-to-trustee transfer between custodians, you do not receive the proceeds, as your current trustee sends the money directly to the new trustee. Since you have no access to the money, the 60 day rule does not apply to trustee-to-trustee transfers and you can move funds in this manner as frequently as you desire.
Small businesses with a maximum of 100 employees sometimes sponsor pensions known as SIMPLE IRAs. Like a regular IRA, the money inside a SIMPLE IRA belongs to you even though your account may contain contributions made by both you and your employer. You can rollover or cash in your SIMPLE IRA at any time. If you withdraw SIMPLE IRA funds within two years of your employer first creating the account you must pay a 25 percent tax penalty. Beyond the two year mark, you pay the same taxes and penalties on SIMPLE IRA, or rollover SIMPLE IRA withdrawals that you pay for qualified or non-qualified withdrawals from other IRA accounts.
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