There are two kinds of individual retirement arrangements, or IRAs: the traditional IRA, which offers a tax-deduction for qualified contributors but generates taxable income; and the Roth IRA, which does not offer a tax deduction in the current year for contributions, but income from these plans is tax free, provided the money has stayed in the Roth at least five years.
Early Withdrawal Rules
Both the traditional and Roth IRA impose a 10 percent penalty on withdrawals made before you turn age 59 1/2. The IRS makes an exception to this rule if you roll the money over to a new retirement plan, or if you commit to taking the withdrawal in substantially equivalent payments over your remaining life span. The rules governing this election are spelled out in IRC 72(t). This rule allows you to tap your retirement assets at any time, as long as you turn it into an annuity, or stream of payments, rather than use it as a short-term savings account for non-retirement-related expenses.
The IRS also allows you to avoid the 10 percent early withdrawal penalty for "hardship distributions." These hardship distributions may be due to the death or disability of the account holder, to pay for medical expenses that amount to more than 7.5 percent of the account owner's income, to pay medical insurance premiums, to avoid foreclosure or eviction, to pay for higher education expenses for yourself or a family member, or to put a down payment of up to $10,000 on a first home.
Traditional IRA Taxation
Any money you take out of a traditional IRA will be taxed as ordinary income, in addition to any 10 percent that may apply. If the money is in a SIMPLE IRA, the penalty could be even higher: Up to 25 percent of the amount you withdraw within three years of contributing to the SIMPLE.
Roth IRA Taxation
You will not pay income taxes on anything you take out of a Roth IRA, provided the money has been in the account for at least five years. The 10 percent penalty still applies, but your contributions will be returned to you tax free. The 10 percent penalty only applies on the earnings in the account, and not to your own contributions. When you take out the money, the IRS considers you to have withdrawn your contributions first, and then your earnings.