Understanding the IRA Withdrawal Rules

Traditional IRA

• A traditional IRA, one in which you contribute on a tax-free basis and pay income tax when you make a withdrawal, has both a qualifying and minimum withdrawal rule. As of 2010, the qualifying rule states that if you make a withdrawal before the age of 59.5, you pay not only the income tax due on the withdrawal but also a 10-percent penalty. For example, if you withdraw $5,000 at the age of 40 and you are currently in a 25 percent income tax bracket, you pay $1,250 in income tax as well as a $500 penalty. An exception to this rule occurs if you qualify for a hardship withdrawal, in which case the penalty does not apply. The minimum withdrawal rule states that you must begin making annual withdrawals by the time you reach the age of 70.5. The Internal Revenue Service establishes a specific amount you must withdraw each year according to your account balance, current age and life expectancy.
  
  

Roth IRA

• A Roth IRA requires that you pay income tax at the time you contribute and as a result, withdrawals are tax-free. A qualifying withdrawal rule applies to a Roth IRA just as it does with the traditional version. However, because you already paid income tax at the time of contribution, you only pay the 10 percent penalty on an early withdrawal unless you qualify for a hardship. Another difference focuses on minimum withdrawals. While there is no withdrawal requirement and no specific amount you must withdraw annually, as of 2010, you must be at least 59.5 years of age and the account must be open a minimum of five years before you can make withdrawals without paying a penalty.
  
  

SIMPLE IRA

• A SIMPLE IRA is different in structure from a traditional or Roth IRA, as this is an employer-based version, but with one exception, withdrawal rules are identical to a traditional IRA. A SIMPLE IRA includes a qualifying and minimum withdrawal rule just as a traditional IRA but as of 2010, includes a two-year period rule. This rule states that if you make a withdrawal in the first two years the account is open, the penalty increases from 10 to 25 percent, unless the withdrawal qualifies as a hardship. For example, if at the age of 40 years you withdraw $2,000 from a one-year old SIMPLE IRA account and are currently in a 25 percent income tax bracket, you pay $500 in income tax as well as a $500 penalty. If you take the same action after the two-year period, you still pay the $500 income tax but the penalty is only $200.
  
  

Considerations

• Withdrawal rules are an important consideration when choosing the right type of IRA. However, withdrawal rules are not the only feature you should consider when choosing an IRA. In addition, if you die before making any withdrawals, each has rules that apply beneficiaries. It is a good idea to consult with a retirement or financial planner before making a decision to ensure you fully understand the benefits of each.