The U.S. Congress authorized the first individual retirement arrangements (IRAs) in 1974 as part of the Employee Retirement Income Security Act. These early IRAs were only available to self-employed taxpayers, and workers who were not covered by a qualified retirement plan at work. Congress later expanded eligibility for IRAs to most taxpayers who had earned income. While there are significant tax benefits associated with IRAs, there are also significant penalties for early withdrawals.
The traditional individual retirement account was the first type of IRA authorized by Congress. Most taxpayers can deduct their contributions to a traditional IRA. Funds in a traditional IRA may be invested in a wide variety of investment vehicles including bank certificates of deposit, stocks, bonds, mutual funds and real estate investment trusts. Any earnings produced by these investments are tax deferred as long as they remain in the account. You can take qualified withdrawals from your traditional IRA once you reach 59 1/2 years of age. Qualified withdrawals are taxed as ordinary income.
Early Withdrawals From a Traditional IRA
All the funds you contribute to your traditional individual retirement account always belong to you, including any earnings produced by investments within your IRA. You can withdraw funds from your traditional IRA at any time, for any reason. The Internal Revenue Service (IRS) considers withdrawals made prior to age 59 1/2 to be early withdrawals. In most cases, early withdrawals are non-qualified. They will be taxed as ordinary income and the IRS will assess an additional tax penalty of 10 percent of the non-qualified amount. There are some exceptions to the age 59 1/2 rule. You may avoid the 10 percent tax penalty if you withdraw funds early to pay certain higher education expenses, to pay for a first home, to pay medical expenses that exceed 7.5 percent of your adjusted gross income, if you become disabled and for certain other reasons. You will always be responsible for paying ordinary income taxes on the withdrawal.
You can only fund your Roth IRA with after tax dollars. You can invest the funds in your Roth IRA in the same types of investments as a traditional IRA. Any earnings produced by these investments are tax deferred as long as they remain in your Roth IRA. Since you have already paid taxes on your contributions, you can withdraw those funds at any time for any reason without initiating a taxable event. Earnings must remain in your Roth IRA account for at least five years before they become qualified. You can take qualified withdrawals of the earnings portion of your Roth IRA once you reach 59 1/2 years of age. Qualified withdrawals are free from federal income taxes.
Early Withdrawals From a Roth IRA
All the funds in your Roth IRA always belong to you, and you can withdraw them at any time, for any reason. There are no taxes due on early withdrawals of amounts equal to the amount you contributed to your Roth IRA. The IRS considers withdrawals of the earnings portion of your Roth IRA made prior to age 59 1/2 to be early withdrawals, which may be non-qualified. The IRS always considers withdrawals of earnings that have remained in your Roth IRA for less than five years to be non-qualified, regardless of your age. Non-qualified withdrawals from your Roth IRA will be taxed as ordinary income and the IRS will assess an additional tax penalty of 10 percent of the non-qualified amount. There are no exceptions to the five-year rule. There are some exceptions to the age 59 1/2 rule, provided the earnings have been in the account for at least five years.
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