Q. How does an IRA work?
A. You invest money in an IRA, up to the amounts allowable under the tax law.
These investments are termed "contributions." In many instances an income tax deduction
is available for the tax year for which the funds are contributed. The contributions, as
well as the earnings and gains from these contributions, accumulate tax-free until you
withdraw the money from the account. You therefore enjoy the ability to generate
additional earnings, unreduced by taxes on these earnings, each year the funds remain
within the IRA.
The withdrawals of the funds from the IRA are termed "distributions." Distributions are
subject to income taxation, generally in the year in which you receive them. (Remember
that in most cases you received an income tax deduction when you contributed the money to
the IRA.) As with most things involving the government, the rules for distributions are
more complicated than they need to be.
Since the original purpose of the IRA is to assist you in providing for your own
retirement, there is a disincentive for withdrawing your IRA funds prior to an assumed
retirement age of 59 1/2. This disincentive takes the form of a tax "penalty" in the
amount of 10 % of the distributions received by you prior to age 59 1/2, unless certain
exceptions apply. Given the complexity of this issue alone, professional advice should
be obtained whenever significant amounts of distributions are needed prior to age 59 1/2.
The fact is that many times the penalty can be avoided with proper planning. Obviously
these distributions, whether before age 59 1/2 or later, are subject to income taxation
upon receipt. Once you are age 59 1/2 this penalty, termed a "Premature Distribution"
penalty, is no longer applicable.
On the flip side of the government not wanting you to withdraw your money at too young
an age, it also has rules to prevent you from not withdrawing the money soon enough.
(This is done in order that the government can tax it.) You usually need to begin taking
money from your IRA no later than April 1 of the calendar year following the date you
attained age 70 1/2. The rules established by the government regarding these Required
Minimum Distributions, their timing, the amounts, the recalculations, and the effect
various beneficiary designations have on them, are among the most complex of the Internal
Revenue Code. The penalty is 50 % of the shortfall between what you should have withdrawn
and the amounts you actually withdrew by the proper date. This punitive penalty is
matched only by the civil fraud penalty in severity. The necessary calculations are
therefore not something that most individuals should attempt on their own.