Individual Retirement Accounts

An Individual Retirement Account (IRA)can be a good way for workers to save for retirement. An IRA is actually an investment or savings product (mutual funds, stocks, bonds, certificates of deposit) that comes with special tax advantages. An IRA account can be opened through a financial institution such as a bank, credit union, mutual fund company, or brokerage firm. Two common types of IRAs are the traditional IRA and the Roth IRA. Both come with tax advantages but the timing of the tax advantage is different.



Traditional IRA

A traditional IRA can be tax deductible for the tax year in which you contribute. For example: In 2010 your taxable income is $40,000 and you contribute $5,000 to a traditional IRA by the tax filing deadline for 2010 which is April 18, 2011. This could reduce your taxable income to $35,000 and thus the amount of federal income taxes you pay. Just how much will be tax deductible depends on whether you are covered by an employer sponsored retirement plan and your income. Your money will grow (hopefully, if your investments go well) tax free. You will not have to pay any taxes until you withdraw the money. You must begin taking money from a traditional IRA by the time you reach age 70 ½. The thinking with a traditional IRA is that at retirement your income will be reduced so you will be at a lower tax bracket and thus end up paying less income tax on the money.

Roth IRA

A Roth IRA is different in that it is not tax deductible for the current year but earnings are tax free, so when you withdraw the money you do not have to pay taxes. For Example: In 2010 your taxable income is $40,000 and you contribute $5,000 to a Roth IRA by the tax filing deadline for 2010 which is April 18, 2011. The $5,000 contribution is not tax deductible and will not reduce the amount of taxes for the 2010 filing year. However, you will not have to pay taxes when you withdraw the money or the earnings as long as you follow the rules (described below). So if your contribution grows to $10,000 you will have avoided paying taxes on the $5,000 of earnings. Another advantage is that there is no requirement to take out money when you reach 70 ½, so it can be a good way to transfer money to your heirs.

Taxes and Penalties on Early Withdrawals

Since these accounts come with tax advantages and are designed to help people save for retirement there are penalties for early withdrawal of funds. If you are under 59 ½ years old, withdrawals from a traditional IRA are taxed at your current federal income tax rate. You will also pay a 10% penalty unless the withdrawal is for a qualifying exception which is described below.

For a Roth IRA, since taxes have already been paid on the contributions, there are no penalties or taxes charged on the amount if you take out only the contributed amount and leave the earnings in the account. If you take out the earnings, you owe the federal income taxes and the 10% penalty if you are younger than 59 ½ years old or have had the Roth for less than 5 years.

Some Examples of Qualifying Exceptions for Traditional and Roth IRAs
If you have an early withdrawal for a qualifying exception - such as a disability, first time home purchase, post secondary education expenses, certain medical or health insurance expenses, or periodic payments taken according to IRS rules - an exception may apply and you may want to consult a tax advisor to see if an early withdrawal penalty can be avoided.

This fact sheet was developed by Lisa Leslie, UF/IFAS Hillsborough County Extension and Anita McKinney, UF/IFAS Duval County Extension, 2011. Extension provides research-based community education. Financial management topics include developing a spending plan, financial goals, debt reduction, credit management, using financial institutions, and saving & investing for future goals. For more information contact Lisa Leslie at (813) 744-5519 x143 or lesliel@hillsboroughcounty.org or Anita McKinney at (904) 387-8850 or McKinney@coj.net 

Florida Cooperative Extension is a cooperative service of Florida county governments and the University of Florida. The Institute of Food and Agricultural Sciences (IFAS) is an Equal Employment Opportunity Institution authorized to provide research, educational information and other services only to individuals and institutions that function with non-discrimination with respect to race, creed, color, religion, age, disability, sex, sexual orientation, marital status, national origin, political opinions or affiliations. U.S. Department of Agriculture, Cooperative Extension Service, University of Florida, IFAS, Florida A. & M., University Cooperative Extension Program, and Boards of County Commissioners Cooperating.