Contributions to a traditional IRA are made with before-tax dollars, and withdrawals are taxed at your individual tax rate at the time of withdrawal. Money taken out of a traditional IRA before reaching age 59½ is considered to be a premature distribution. In addition to owing any tax that might be due, there is a 10 percent penalty charge. There are exceptions in the tax code to allow penalty-free withdrawals under certain circumstances including higher education expenses or a first-time home purchase. Up to $10,000 may be withdrawn to buy or build a first home. If both you and a spouse are first-time home buyers, each of you can receive distributions up to $10,000. Be sure to check IRS Publication 590, "Individual Retirement Arrangements," for the precise definition of a first-time home buyer. Withdrawals for qualified education expenses also are allowed penalty-free. However, education withdrawals may not be the best idea. You will miss out on further tax deferral on your invested dollars, and the added income may make it harder to qualify for financial aid at your selected college.
Contributions to a Roth IRA are made with after-tax dollars and thus are not taxed at withdrawal. Roth IRA earnings are not taxed if: 1) the withdrawal is made at least five years after the first Roth IRA contribution was made, and 2) you are at least 59½ years old, are disabled, or use the funds for first-time home purchase. Remember that any portion of a Roth IRA distribution that is not used for a qualified purpose will be subject to an additional 10 percent tax on early distributions. Before deciding on a traditional IRA or Roth IRA, you should check the tax implications. Both the 401(k) and the traditional IRA (if income-eligible) are funded with pre-tax dollars, making this type of roll over simple. With Roth IRAs, you will first need to roll over your 401(k) balance to a traditional IRA and then convert amounts from a traditional IRA into a Roth IRA. Since the Roth IRA is funded with after-tax dollars, you will have a tax liability to adjust for the taxes you did not pay on the money that originally went into your 401(k) account. There are also income limits that restrict the availability of Roth IRA accounts. Check Chapter 2 of IRS Publication 590, or check with your tax adviser. Once you are aware of the income requirements and potential tax implications, you should ask a financial institution to provide a comparison of the two IRAs prior to your purchase. IRS publications may be found at the IRS Web site at www.irs.gov.
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