Congress created individual retirement accounts (IRAs) as a way for workers to save for retirement. IRAs have evolved into more diverse investment vehicles, offering leeway if you want to use the funds to pay for college or first-time home buyer expenses. Through it all, the tax benefits associated with IRAs remain. The type of account you have and when you access your money dictate the tax implications of liquidating an IRA.
Traditional IRAs provide a tax benefit to you now, and the tax perk from a Roth IRA comes during your retirement. The IRS allows you to deduct money you contribute to a traditional IRA from your taxable income each year, up to an annual limit. With a Roth IRA, you contribute after-tax money. However, the IRS never taxes your original contributions when you access your money. It's important to know and understand these distinctions as you consider what will happen as the result of account liquidation.
After you reach age 59-1/2, you'll pay taxes on the entire amount of all traditional IRA withdrawals. In fact, the IRS charges regular income tax -- at your tax bracket at the time -- on traditional IRA distributions, regardless of time and circumstance. If you have held your Roth account for at least five years, the IRS does not charge tax on Roth withdrawals, including earnings that accumulated on top of original contributions, provided you ask for the liquidation after you turn 59 1/2.
If you liquidate an IRA account prior to turning age 59-1/2, the IRS generally assesses a 10 percent tax penalty, and taxes the withdrawal at your income tax rate. There are some exceptions to this rule, such as if you become disabled or use the funds to purchase a first home, the details of which can be found in IRS Publication 590. In a Roth IRA, the 10 percent penalty only applies to earnings, such as capital gains and dividends. You'll never pay tax on original contributions you remove from a Roth. When you ask for a Roth withdrawal, your IRA custodian takes out original contributions first followed by other money, including earnings. With a traditional IRA, the entire amount of an early withdrawal gets slapped with the 10 percent penalty in addition to regular income tax.
While you do not have to completely liquidate your traditional IRA, the IRS does require traditional IRA owners to begin taking required minimum distributions (RMDs) by April 1 of the year after they turn 70-1/2, at the latest. After turning 70-1/2, you must take annual RMDs from your traditional IRA.