If creating your retirement plan has not been a priority, it is not too late to start. Although Social Security will provide a sparse amount of retirement income, it will not guarantee a comfortable retirement. Instead, you need to make a retirement plan for yourself, so your golden years can be as relaxing as you imagine they will be. An IRA is a great investment tool that allows you to plan, save and invest in your retirement. A common question, though, is how are IRA withdrawals taxed during retirement?
What is an IRA and how does it work?
An IRA is basically an investment account, with various tax advantages, that allows you to save money for retirement. Regardless of whether you have a traditional or Roth IRA, you will not pay taxes on any earnings for the account. Instead, the earnings are reinvested and compounded to allow your account to experience even more growth. Then, once you retire and begin to make withdrawals from the IRA, the amount you pay in taxes will depend on three factors: the type of IRA you have, your income and the amount of your withdrawals.
What makes traditional IRAs different?
A traditional IRA is funded with “pre-tax” dollars, meaning that you do not pay any taxes on your contributions or the interest they earn, until you start taking withdrawals during retirement. Then, each withdrawal is taxed as ordinary income. For instance, if based on your income, you owe 20% tax on your income and you take a withdrawal of $10,000 during the tax year, you will owe $2,000 in federal and state income tax.
Roth IRAs are taxed differently from traditional IRAs
A Roth IRA, on the other hand, is funded with “after-tax” dollars. A Roth IRA does not provide any tax benefits relating to contributions. However, the earnings and withdrawals from Roth IRAs are typically tax free. A major advantage to a Roth IRA is that not only are your earnings allowed to grow tax-free, but when you retire and take withdrawals, you pay no income taxes. In essence, you avoid taxes when you contribute to the traditional IRA, but you avoid taxes with the Roth IRA when you withdraw money at retirement.
Early withdrawals from a traditional IRA
With any type of IRA, the IRS will charge a penalty for any early distributions or withdrawals. With a traditional IRA, you will be required to pay an additional 10% penalty if you take any distributions before you reach the age of 59½. That is in addition to the income taxes that are imposed.
Early withdrawals from a Roth IRA
One benefit of a Roth IRA is that you are allowed to withdraw your original contributions at any time, without penalty. That is because you have already paid income tax on those funds. However, early withdrawals of any of your earnings will be subject to the 10% penalty, in addition to income tax for withdrawals beyond the initial contributions. The Roth IRA has an additional requirement. Along with the age requirement of 59½, the Roth IRA must be established for at least five years before you can begin to withdraw earnings, without penalty.
If you have questions regarding IRA taxation, or any other retirement planning needs, please contact Anderson, Dorn & Rader, Ltd., either online or by calling us at (775) 823-9455.
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