Taxable Amount of IRAs

IRAs, or individual retirement accounts, function as tax shelters. These tax shelters defer income taxes due on your retirement savings so that you may invest this savings for your future. However, when you withdraw money from your IRA, you must know how these IRA funds are taxed.

Types

• There are two types of IRAs: traditional and Roth IRAs. Traditional IRAs accept tax-deductible contributions. Roth IRAs accept only after-tax contributions. Both types of IRAs defer income taxes while the money is in the IRA account and may invest in a wide range of investments, including mutual funds, stocks, bonds, real estate and precious metals.

Function

• A traditional IRA functions as a tax shelter that postpones current taxation in exchange for future taxation. When money is withdrawn from a traditional IRA, taxes are due on the full withdrawal amount. The money is taxed at ordinary income tax rates. Money contributed to a Roth is included as gross income and taxed at ordinary income tax rates. When money is withdrawn from a Roth IRA, no taxes are due provided the withdrawals are made during retirement.

Benefit

• The benefit of a traditional IRA is that current taxes are deferred. No taxes are paid on the contributions to the account, which means you can potentially accumulate a large retirement savings. The benefit of a Roth IRA is that you receive tax-free withdrawals during retirement.

Warning

• If you withdraw money from either IRA prior to age 59 1/2, you will be subject to a 10 percent penalty in the form of an excise tax. For traditional IRAs, this penalty is on the entire withdrawal amount. For Roth IRAs, this penalty is only on the investment earnings. This penalty is in addition to ordinary income taxes due on the withdrawals in both cases.

Considerations

• If you are not sure what future tax rates will be like, consider using both a traditional and a Roth IRA. By contributing to both types of accounts, you get the benefits of both types of accounts. You also accept the risks of both types of accounts. However, if you decide that you'd prefer to have just one IRA over another, you may transfer one IRA to another. If you are moving the Roth IRA to a traditional IRA, the contributions will remain after-tax and you must keep a personal record of these by filing IRS Form 8606. Any future investment earnings in the traditional IRA will be taxed at ordinary income tax rates.