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Individual retirement accounts are an excellent way for taxpayers to save for retirement. Even though the principal focus of IRAs is to fund retirement, tax rules allow penalty-free IRA withdrawals for several purposes other than retirement. Of course, "penalty-free" is not the same as "tax-free." Also, the tax rules are different for traditional IRAs and Roth IRAs.
Traditional IRAs are typically funded with annual tax-deductible contributions. These IRAs can also contain untaxed rollovers from retirement plans, such as 401(k) accounts. Traditional IRAs are designed to shelter funds from taxation until the account owner begins taking withdrawals. Roth IRAs, on the other hand, are funded with after-tax contributions, but earnings grow tax-free. Retirement withdrawals from Roth IRAs are tax-free.
IRAs were designed to be retirement accounts; therefore, "early withdrawals," which are generally defined as distributions taken before age 59-1/2, may be subject to a 10% tax penalty. (In the case of Roth IRAs, the account must also have been open for five years.) The 10% penalty is in addition to income tax on previously untaxed balances. For traditional IRAs, an early withdrawal may trigger the 10% penalty plus regular income tax on the total amount of the withdrawal. An early withdrawal from a Roth IRA may trigger a penalty and regular income tax on the accumulated earnings in the account.
Tax rules define several circumstances in which early withdrawals are not subject to a penalty, but still will be subject to regular income tax. These rules apply to both traditional and Roth IRAs.
For example, taxpayers can avoid the 10% penalty if they use IRA withdrawals to pay "qualified" higher education costs. These costs can be for the taxpayer, the taxpayer’s spouse, children, or grandchildren. "Qualified" first-time homebuyers also may make penalty-free withdrawals to pay certain home acquisition costs.
Still other rules provide penalty-free withdrawals to pay deductible medical expenses. Unemployed individuals may make penalty-free withdrawals to purchase health insurance. Other penalty exceptions apply to "IRA annuities," which represent a planned sequence of withdrawals, and to withdrawals caused by the death or disability of an IRA owner.
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