An Individual Retirement Account, IRA, is an investment account that affords certain tax advantages if you observe Internal Revenue Service regulations. There are many kinds of IRA accounts, from those that can be established by individuals to those that an employer must sponsor. The tax treatment of IRAs can vary from type to type.
Tax Treatment of Contributions
Contributions to most IRAs are made on a pre-tax basis. For Traditional and SEP-IRAs, you can take a deduction for qualified contributions on your income tax return, while for SIMPLE IRAs, contributions are made on a salary-reduction basis, before income taxes are taken out. Traditional and SEP contributions can be deducted if you are not covered by another retirement plan at work, or if you are covered by a plan and your modified adjusted gross income falls within IRS-mandated limits. A deductibility matrix is provided in IRS Publication 590.
Earnings Growth
One of the main benefits of IRA accounts is that earnings grow on a tax-deferred basis, meaning you don't have to include earnings as income in your annual tax filings.
Taxation of Distributions
As most IRAs are tax-deferred, you must pay tax when you take distributions. Even if all of your gains in an IRA are from capital gains, your distributions will be taxed at ordinary income tax rates.
Required Minimum Distributions
The IRS requires that you begin taking distributions from your tax-deferred IRA accounts by April 1 after the year you turn 70 1/2. Distributions must continue on an annual basis thereafter. The amount of the distributions is computed from your account value and your life expectancy, as shown in Appendix C of IRS Publication 590. Even though these distributions are mandatory, you are still required to pay ordinary income tax on them.
Tax Penalties
If you disregard taking a required minimum distribution, the IRS will penalize you 50 percent of the amount that you should have withdrawn. In addotopn, if you take any IRA distributions before you reach age 59 1/2, you must pay a 10 percent penalty in addition to ordinary income tax. The few exceptions to this penalty are outlined in IRS Publication 590 and included distributions due to excess medical expenses or disability.
Roth IRAs
Unlike all other IRAs, contributions to a Roth IRA are made on an after-tax basis, meaning you pay tax on your contribution before you make it. In exchange for this upfront tax payment, your distributions are tax-free. In addtion, there are no required minimum distributions for Roth IRAs. The 10 percent early withdrawal penalty does apply to Roths, and extends to distributions taken within five years of establishing a Roth account.
Member Comments