Setting money aside in an IRA delays taxes on your savings, but you may owe taxes when you tap into your next egg during retirement. Rules for IRA withdrawals depend on the type of account you own. In general, you pay taxes on withdrawals from traditional IRAs but you may not owe tax when you cash out a Roth IRA.
Traditional IRAs let you save money with pre-tax dollars, but then you have to pay income tax on withdrawals. The tax rate you pay on traditional IRA withdrawals is your ordinary income tax rate based on your taxable income in the year of withdrawal. For instance, if your taxable income is $50,000 in 2013 as a single taxpayer, you are in the 25 percent income tax bracket, so you would face a 25 percent tax rate on IRA withdrawals.
You make contributions to a Roth IRA with after-tax dollars, so you've already paid income tax on the cash you save in a Roth. You can therefore withdraw your Roth IRA contributions at any time, tax-free. Withdrawals of investment gains from a Roth IRA are also tax-free if you wait at least five years after opening your account and until age 59 1/2 to cash out. Investment gains you withdraw are taxed as ordinary income if you don't meet the requirements to make a tax-free withdrawal.
Taking money out of an IRA before age 59 1/2 is considered an early distribution. Early distributions are generally subject to 10 percent tax penalty in addition to the normal income tax rate that applies. For traditional IRAs, the penalty typically applies to the entire withdrawal; for Roth IRAs, the penalty only applies to the investment gains. In addition, the penalty does not apply in certain special cases, such as withdrawals made because you're disabled, you've inherited an IRA, you're buying or building a first home, or you're paying for certain medical and educational expenses.
The size of the withdrawal you make from an IRA can affect the tax rate you pay. One of the advantages of traditional IRAs is that workers often have lower taxable income during retirement, so delaying taxation until retirement can result in paying a lower tax rate. If you make a large withdrawal from a traditional IRA, however, it could push you up to a higher income tax bracket and increase the tax rate you pay on your withdrawal. With regard to paying taxes, it is usually more advantageous to take funds out of a traditional IRA over the course of several years than to cash out your entire account in one year.
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