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.
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 a minimum withdrawal amount at age 70½.
Roth IRARoth IRA is just the opposite tax-wise. You pay with after-tax money into a Roth where it has the potential to grow tax-deferred. If you have your Roth IRA for at least five years and are age 59½ or older, you don't have to pay 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 money out at age of 70½. 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 (if they set it up correctly).
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 (opens new window). Also, just like any other contribution going into a Roth, if you rollover an existing Traditional IRA or 401k, 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.
The information herein is not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding tax penalties. Taxpayers should seek advice based on their own particular circumstances from an independent tax advisor.
Securities and investment advisory services offered through Voya Financial Advisors, Inc. member SIPC.
Neither Voya nor its affiliated companies provide tax or legal advice. Please consult with your tax and legal advisors regarding your individual situation.