There are two primary types of individual retirement accounts (IRAs): traditional and Roth. Both types of IRAs have significant, but different, tax advantages. Investments in both types of accounts grow tax deferred. Qualified withdrawals from a traditional IRA are taxed as ordinary income, while qualified withdrawals from a Roth IRA are free from federal income taxes. You can close your IRA before you are able to retire, but you will likely have to pay a stiff penalty.
Contributions to a traditional IRA are made with pretax dollars and all growth of investments inside the account are treated the same, regardless of whether it comes from dividends, interest or capital gains. You can begin taking qualified withdrawals from your traditional IRA once you reach 59 1/2. All funds in your traditional IRA always belong to you and you can withdraw them at any time. If you have to close your traditional IRA before you reach 59 1/2, your withdrawals will be taxed as ordinary income, and the IRS will charge you a tax penalty equal to 10 percent of the non-qualified withdrawal.
Traditional IRA Exceptions
All withdrawals from your traditional IRA are subject to taxation as ordinary income in the year you make the withdrawal, but you may be able to avoid the additional 10 percent tax penalty if you meet certain requirements. You can close your IRA without incurring a tax penalty if you have unreimbursed medical expenses that exceed 7.5 percent of your adjusted gross income. You can also avoid the tax penalty if you close your account if you are disabled. You can close your IRA without penalty if you use the funds to pay for certain expenses associated with post-secondary education for yourself or your family members, or to buy or build a first home.
Contributions to a Roth IRA are made with after-tax dollars and all growth of investments inside the account are treated the same. Because you have already paid income taxes on the money you contributed to your Roth IRA, you can withdraw an amount equal to your contributions at any time, and for any reason, without causing a taxable event. Any earnings in the account must remain in the account for at least five years to qualify for tax-free distribution. You can start taking qualified withdrawals from your Roth IRA once you reach age 59 1/2. If you close your account before the earnings have been in the account for at least five years, or before you reach age 59 1/2 years, the earnings in your Roth IRA will be taxed as ordinary income, and you will be accessed an additional 10 percent tax penalty.
Roth IRA Exceptions
If you have to close your Roth IRA before the earnings have been in the account for at least five years the earnings will always be taxed as ordinary income, but you may be able to avoid the tax penalty for withdrawing prior to reaching age 59 1/2. You can avoid the tax penalty if you use the proceeds to pay for higher education expenses, premiums for medical insurance after losing a job, a first home, or if you are disabled.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.