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There are two types of individual retirement accounts (IRA) available to most Americans, the traditional IRA and the Roth IRA, and each type has a different set of rules for determining the tax on an IRA withdrawal. The owners of traditional IRAs contribute “pre-tax” dollars, which are contributions that are tax-deductible up to an annual cap. Those contributions, plus any earnings, are taxed as ordinary income only when withdrawn. Conversely, contributions to Roth IRAs are made with post-tax dollars, and can be withdrawn at any time tax-free. In addition, the earnings on a Roth IRA are also tax-free upon withdrawal if certain conditions are met. Some states impose additional tax on an IRA withdrawal, and the rules vary by state.
Traditional IRAs were first introduced in the 1970s as a way for people to save for their own retirement, and so they are intended to grow at least until the owner turns 59½. Withdrawals made before that time are taxed as ordinary income, and in most cases, a 10% penalty is levied as well on early withdrawals. IRA owners must take annual withdrawals in a minimum amount, called the required minimum distribution (RMD), starting in the year they turn 70½. Failure to take the full RMD incurs a 50% tax liability on the amount not taken. For example, if an IRA owner withdraws $1,000 less than the RMD in any year, she’ll be liable for a $500 tax, and if she doesn’t take the RMD at all, she’s liable for a 50% tax on the entire amount of the RMD.
The owner of a Roth IRA, on the other hand, generally pays no tax on an IRA withdrawal, since the contributions were taxed prior to being put into the IRA. In addition, withdrawals of earnings from a Roth IRA are also tax-free, subject to qualifying conditions. If fewer than five years have elapsed since the opening of the account, the earnings are taxed as ordinary income and a 10% penalty is assessed. Once the five-year “seasoning period” has passed, though, earnings may be withdrawn tax-free if any one of a number of conditions is met. For example, if the owner reaches age 59½ or becomes disabled, or withdraws the money to use for certain expenses associated with buying a first home, the earnings will not be taxed. In addition, the Roth IRA has no RMD, making it an attractive savings vehicle for accumulating wealth to pass on to one’s heirs.