Traditional individual retirement accounts are popular because you can usually take a tax write-off for your contributions -- but the tax benefits of IRAs don't stop there. Whether you even pay taxes or penalties on the IRA income depends on which type of IRA you have and when you're taking distributions.
Earnings in IRA
The earnings in your IRA won't generate taxable income for you as long as you leave them undisturbed in the account. Both traditional and Roth IRAs offer tax-sheltered growth, which means that any income -- such stock gains, dividends or interest -- in the account doesn't add to your taxable income until you take it out, which is usually during retirement.
Qualified Withdrawal Requirements
To minimize the amount you pay on your distributions, wait until you can take qualified withdrawals. For traditional IRAs, that means you need to be at least 59 1/2 years old. When you do this, your traditional IRA distributions are still taxed as any other income, but you do not pay any tax penalty. For Roth IRAs, it means you need to be either 59 1/2, permanently disabled or taking out no more than $10,000 for a first home, plus your Roth IRA must be at least five years old. Qualified Roth IRA withdrawals come out tax-free and penalty-free.
If you're taking an early withdrawal from your traditional IRA, you still get taxed and you have to pay a 10 percent early withdrawal penalty. For example, a $4,000 early withdrawal gives you an extra $4,000 in taxable income plus a $400 penalty. For Roth IRAs, you get your all contributions out first -- tax- and penalty-free. But, if you take early withdrawals of earnings, you get hit with taxes and the early withdrawal penalty. With an early withdrawal from either account, you can skip out on the penalty, but not the taxes, if you qualify for an exception such as paying for college tuition or health insurance when you're unemployed.
The taxable portion of your IRA withdrawal counts as ordinary income. Sorry, no lower capital gains rates even if you were holding the stocks in the IRA for years. So, the higher your tax bracket, the larger your tax bill from IRA distributions. For example, say you're in the 28 percent bracket and you take out $20,000, all taxable, from your IRA. Assuming you're not pushed into the 31 percent bracket, you share $5,600 of that distribution with Uncle Sam. The first $19,000 is still taxed at 28 percent with just the last $1,000 taxed at 31 percent.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."