IRAs and taxes

Traditional IRAs and Roth IRAs. Both of these Individual Retirement Accounts (IRAs) have real, and sometimes frustrating, tax consequences. They just have them at different times.

In spite of all the talk about “tax-free” and “tax-deferred,” there are still taxes to be paid on an IRA. The “taxable event” depends primarily on what type of IRA you have.

Traditional IRA

In this type of IRA, if you meet certain income qualifications, you make your contribution on a pre-tax basis. While not everyone can contribute pre-tax contributions, for those who can, using them to fund your IRA reduces your taxable income in that year, which could lower your adjusted gross income and qualify you for other tax advantages. Once your money is in your Traditional IRA, it has the potential to grow tax-deferred. But once you turn 59½ you can begin to take the money out without penalties, and you pay regular income tax on your withdrawals.

The thinking behind this is that when you retire, you may have a smaller income so you may be in a lower income tax bracket.

And what happens if you withdraw before age 59½? The withdrawal is taxed at your regular income rate plus you must pay a 10% early withdrawal penalty unless an exception applies. And finally, you must start taking required minimum distributions. These must begin April 1st of the year following the calendar year in which you reach age 70½, if you were born before July 1, 1949. April 1 of the year following the calendar year in which you reach age 72, if you were born after June 30, 1949. For each year after your required beginning date, you must withdraw your RMD by Dec. 31.

Roth IRA

Roth IRA is just the opposite tax-wise. You contribute after-tax money into a Roth where it has the potential to grow tax-free — i.e., if you have your Roth IRA for at least five years and amounts are distributed from the Roth IRA after you reach age 59½, die or take a distribution for the purchase of a first home, you don’t have to pay federal (and potentially state) income tax when you take the money out. This is called a qualified distribution.

If you take withdrawals that are not “qualified,” you may be hit with income taxes on the earnings and a 10% IRS penalty. If you’re under age 59½, you can take withdrawals without penalty under certain IRS-approved exceptions. There are no age restrictions. You don’t have to start taking required minimum distributions. In fact, it’s possible to never touch the money in your Roth IRA and leave the account to your beneficiaries who would then have a source of tax-free money for years. Your beneficiaries would, however, be required to take minimum distributions from the IRA.

There is an income qualifier with the Roth. This varies by tax year and whether you are filing single or jointly. You can find this information at IRS.gov. Also, just like any other contribution going into a Roth, if you roll over an existing Traditional IRA or 401(k), you will have to pay income tax on the rollover amount.

Regardless of whether you choose a Roth IRA or a Traditional IRA, talk with a knowledgeable tax adviser about any possible tax consequences before you make your final decision.