The tax code offers two types of IRAs; one is referred to as the traditional individual retirement account (IRA), so named because it was the first type of IRA available, having been created by Congress back in the 1970s. The second type is the Roth IRA, established in 1997 and named after William Roth, who was a senator from Delaware. Which one is best for you?
If you are suddenly in need of a substantial amount of cash, probably the last thing you should do is tap your retirement funds. They are the key to a financially comfortable retirement. The younger you are, the less likely you are to think about saving for retirement, but you certainly don’t want to end up living off of only Social Security. However, there are times when there might not be any other alternative than dipping into your 401(k), IRA or other retirement plan. In that case, you have to be concerned not only with any tax liability, but also early withdrawal penalties if the funds are withdrawn before reaching age 59 1/2 Plus, some distributions may only be partially taxable and some not taxable at all, while others are fully taxable.
Like everything in the U.S. tax code, the rules relating to pension or other retirement plan distributions are complicated and governed by a variety of provisions. This article describes these various rules so you can see how they would apply to a withdrawal you might be contemplating.
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Tax law permits you to take a distribution from your IRA account, and as long as you return the distribution to your IRA within 60 days, there are no tax ramifications. However, many taxpayers overlook that you are only allowed to do that once in a 12-month period, and violating this rule can have some nasty and unexpected tax ramifications.
The one-year period is measured based on the date a distribution is received. If the second distribution is received before the same date one year later, it is a disqualified rollover.
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If you have an IRA account or are considering one, there are a number of potential missteps you will want to avoid. Some of them can lead to unwanted taxes and penalties, and of course, we are talking about your retirement funding, so it is an important issue. Here are a number of issues to keep in mind:
Roth IRA accounts provide the benefits of tax-free accumulation and, once you reach retirement age, tax-free distributions. This is the reason why so many taxpayers are converting their traditional IRA account to a Roth IRA. However, to do so, you must generally pay tax on the on the converted amount. After making a conversion, your circumstances may change, and you may find yourself wishing you had not made the conversion. In the past, you could change your mind later and undo the conversion. But that option is no longer available under tax reform. So, be careful: once a conversion is made, there is no going back.
Timing is everything, and a favorable time to make a traditional IRA to Roth IRA conversion is a year when your income is abnormally low or the value of your traditional IRA has declined. You can also convert portions of your traditional IRA over a number of years, thereby gradually converting the traditional IRA to a Roth IRA, spreading the tax liability over a number of years, and keeping it in a lower tax bracket. If you previously made non-deductible contributions to a traditional IRA, those amounts can be converted tax-free but must be converted ratably with the other funds in the traditional IRA.
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Taxpayers can take a distribution from an IRA or other qualified retirement plan and if they roll it over (put it back) within 60 days they can avoid taxation on the distributed amount. (This provision does not apply to required minimum distributions for taxpayers who are 70.5 years of age and over.) In addition, taxpayers are limited to one IRA-to-IRA rollover per year.