A Roth IRA presents a unique benefit: The contributions that you make to a Roth IRA during the year aren't tax-deductible -- but when you withdraw money from a Roth IRA, none of these dollars are taxed. You will, though, have to follow certain rules to avoid paying penalties when taking money out of a Roth IRA.
The magical age for a withdrawal from a Roth IRA is 59 1/2. If you withdraw money after you reach this age, you won't have to pay taxes or a government penalty for taking out your money. And this holds true for whatever earnings your Roth IRA made, too. Be aware, though, that you must have had your Roth IRA for at least five years before making a withdrawal. If you haven't, you'll be taxed on your withdrawal, even if you've already turned 59 1/2.
A Roth IRA differs from a traditional IRA in one major way: When you make a contribution to a traditional IRA during the year, those contributions are tax deductible. When you withdraw funds from a traditional IRA, you will have to pay your normal income taxes on this withdrawal. Basically, a traditionally IRA is good for investors who want to save money now. A Roth IRA is good for investors who want to take their savings in the future, when they withdraw their money with no tax penalties.
Withdrawing funds from a Roth IRA before you hit 59 1/2, or when you've had your IRA for less than five years, can be costly. You'll have to pay regular income taxes on your earnings. You'll also suffer a 10 percent early withdrawal penalty on your earnings. Here's an example: Say you contributed $4,000 to a Roth IRA. That IRA's worth grew to $5,000 before you decided to cash it out on your 40th birthday. If your income-tax bracket is 28 percent, you'll play $280 of income taxes on your $1,000 profit. You'll also pay a 10 percent penalty of $100 on that profit, meaning that you'd pay a total of $380 on your Roth IRA profit of $1,000.
The good news is that you'll never face taxes or penalties when you withdraw the principal contributions that you've made to a Roth IRA. Principal contributions are the dollars that you have invested into a Roth IRA over the years, as opposed to the earnings that those dollars have experienced. You can also avoid the 10 percent early withdrawal penalty if you use the funds from a Roth IRA to purchase your first home or to pay for secondary education at an accredited college or university.