The rules for IRA withdrawals are very different, depending on whether you have a traditional IRA or a Roth IRA. Here’s a breakdown.
If you have a traditional IRA, you‘ll want to proceed with extreme caution before withdrawing any funds from your account before you reach age 59 ½. That’s because, except under very specific circumstances, you’ll pay a 10% penalty for every withdrawal you make. And that’s in addition to paying income tax on the money you take out. Not to mention the fact that, if the money’s not in your retirement account, you’re losing out on it’s potential investment growth.
So, what are some of the circumstances under which you won’t pay an early withdrawal penalty, even if you’re under age 59 ½ ?
If you become permanently disabled
If you take money out to pay for certain medical expenses
If you’re paying for certain educational expenses
If you’re making a qualified first home purchase (withdrawal can be up to $10,000)
The rules for a Roth IRA are different. Because contributions to a Roth are made with after-tax dollars, you can make withdrawals from your Roth, up to the amount you’ve contributed, tax- and penalty-free, regardless of your age.
When it comes to earnings on your Roth IRA, the rules concerning taxes and penalties can get a little tricky. Generally, as long as you’re at least 59 ½ and the account has been open for at least 5 years, then you’ll pay neither taxes nor penalties.
If you’re younger than 59 ½, though, you’ll have to pay income tax plus a 10% penalty on the withdrawal of any earnings, unless you meet one of the hardship requirements.
As with a traditional IRA, perhaps the biggest drawback to taking an early withdrawal from your Roth IRA is that you lose all potential for that money to continue to grow, and fund your retirement.
When it comes to retirement planning, an IRA is a great savings option. If you’re an individual establishing your own IRA, you have two basic options:
Traditional IRATax Deferred: A traditional IRA is a tax-deferred savings plan. This means that you don’t pay taxes on money when you contribute it to your IRA, but you do pay income tax down the road, when you withdraw money from your IRA during retirement.
Income Limits: While there’s no maximum amount you can earn each year and still contribute to a traditional IRA, there is a rule concerning minimum income. You can’t contribute more to your account than you’ve earned in any given year.
Contribution Limits: Currently, you can contribute up to $5,000 each year to your traditional IRA. If you’re age 50 or older, that amount increases to $6,000.
Early Distribution: You’ll need to keep your money in your traditional IRA until you reach age 59 ½. Aside from very specific exceptions, withdrawing money before this point will mean that, in addition to paying income tax on the amount withdrawn, you’ll also pay a 10% penalty.
Required Minimum Distribution: Once you reach age 70 ½, you’ll have to take a minimum amount out of your account each year. Exactly how much of a distribution will be required depends on your account balance and your life expectancy. Failure to take the appropriate distribution will result in a 50% penalty.
Roth IRATax Free: A Roth IRA is a tax-free savings plan. What this means is that, while you make contributions with after-tax dollars each year, when you ultimately withdraw funds from your account during retirement (assuming you comply with the rules), you won’t pay income taxes on any portion of your withdrawal. So, you’re not taxed on the interest earned by your IRA.
Income Limits: Not everyone is eligible to contribute to a Roth. If you’re single, the amount you’re allowed to contribute is phased out if your annual income is above $105,000, and you’re not allowed to contribute at all if you make more than $120,000. If you’re married filing jointly, the phase out begins at $167,000, and you’re ineligible to contribute if you and your spouse make more than $177,000.
The Roth also has a minimum income limit -- you can't contribute more than you've earned.
Contribution Limits: The contribution limits for a Roth IRA are the same as for a traditional IRA. For 2010, those under 50 can contribute $5,000 annually. If you’re 50 or older, you can contribute $6,000.
Early Distribution: Because your contributions are made with pre-tax dollars, as long as you follow the rules of your IRA, you can withdraw the amount you’ve contributed any time, penalty-free. If you withdraw account earnings before you reach age 59 ½, you’ll pay a 10% penalty (there are certain limited exceptions).
Required Minimum Distributions: There are no Required Minimum Distributions associated with Roth IRA’s.
You can have more than one IRA, and you can have both a traditional and a Roth IRA. If you have more than one IRA, the annual contribution limit applies to all your accounts, together. So, if you’re 52 and you contribute $4,000 to your Roth, you can contribute $2,000 to your traditional IRA.