All the financial advisers tell you to save for retirement. It's an idea that gets better when you can get tax breaks to help you save for your future -- and that's exactly what IRAs provide. You get a bigger nest egg and a smaller tax bill. The IRS does have strict rules regarding taxes on IRA accounts that you need to know to get the most benefit from your IRA.
When you contribute money to a traditional IRA, you get to deduct the amount you contribute on your tax return. Since you can put $5,000 a year into an IRA, it is a pretty hefty tax break. The limit increases to $6,000 when you turn 50. The same applies to employer-provided SEP (Simplified Employee Pension) and SIMPLE (Savings Incentive Match Plan) IRAs as well, except they have higher annual contribution limits. You don't get a tax deduction for contributing to a Roth IRA. Instead, earnings in the account are tax exempt when you withdraw the money after retirement.
You are supposed to leave money in an IRA until you turn age 59 1/2. No taxes are levied on funds as long as they are in an IRA. If you withdraw funds early, the IRS tacks on a 10 percent penalty tax in addition to ordinary income taxes on the withdrawn money. For Roth IRAs, there's an additional rule: the IRA must be at least five calendar years old. The penalty tax may be waived if the money is used to pay for health insurance if you are unemployed or medical expenses in excess of 7.5 percent of your adjusted gross income. The penalty is also waived if you are disabled, have to pay an IRS levy, or the money is used to pay for a first home or qualified education expenses. You can arrange to start taking the money out early in substantially equal annual payments for at least five years, or until you turn 59 1/2, whichever is longer.
Once you reach age 59 1/2, you can start making distributions from your IRA without any tax penalties. You do have to pay ordinary income taxes on most distributions from a traditional IRA. In addition, you must start receiving mandatory minimum distributions from a traditional IRA when you reach age 70 1/2 on a schedule designed to empty the account within your life expectancy. If you don't make a minimum distribution, the money not withdrawn is subject to ordinary taxes pus a 50 percent excise tax. There are no such restrictions on Roth IRAs. You can leave the money in the account as long as you like and it is not taxed when you do take it out.
If you "roll over" money from a traditional IRA or other tax-deferred retirement account into a Roth IRA, you have to pay the taxes that would have been due if you had left the money in the original account and withdrawn it after retirement. However, since the taxes on the rolled over funds have been paid, the money won't be subject to any income taxes when you withdraw it after you reach age 59 1/2.
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