An individual retirement account is a retirement savings vehicle that you open and manage yourself, which gives you the freedom to choose your investments and withdraw money when you need it. IRA withdrawals may be subject to federal income tax, depending on the type of IRA you open, as well as a penalty for any early withdrawal. Cashing in an IRA may also cause you to incur fees imposed by the financial institution where you opened your account.
Tax on Traditional IRAs
IRAs come in two basic types: traditional IRAs and Roth IRAs. When you open a traditional IRA, your contributions are tax-deductible if you don't have access to a retirement plan as a job benefit or if you meet certain maximum income requirements. Investments in an IRA grow tax-free, but you have to pay income tax on withdrawals of investment gains and tax-deductible contributions. In essence, a traditional IRA lets you delay paying income tax on contributions until you take the money out during retirement.
Roth IRA Withdrawals
Roth IRA contributions are not tax-deductible, so you have to fund a Roth IRA with after-tax money. On the other hand, you don't owe income tax on withdrawals of Roth IRA contributions. Withdrawals of investment gains are also tax-free as long as you make them after age 59 1/2 and at least five years after opening your account. In other words, a Roth IRA lets you pay taxes upfront and avoid taxes during retirement.
IRA withdrawals made before you reach 59 1/2 are considered "early distributions." Early distributions from a traditional IRA are subject to a 10 percent tax penalty in addition to normal income taxes. Roth IRA contributions are not penalized if you take them out early, but early withdrawals of investment gains are subject to the penalty. You can avoid the penalty if you withdraw funds in certain cases, such as to pay higher education expenses, buy or build a first home, or if you have medical expenses that exceed 7.5 percent of your adjusted gross income.
Cashing in an IRA may involve paying fees in addition to taxes. You can open an IRA at different types of financial institutions, such as mutual fund companies, banks and stock brokerages. Financial companies can charge transaction fees when you sell investments; fees are common when trading individual stocks. Some mutual funds have holding period requirements, under which you incur a fee if you sell shares before holding them a minimum number of days.
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