Q: My husband and I each took $10,000 early IRA distributions to help pay for a construction loan on a new house.
The amount is exempt from the 10% penalty but I do not understand, when it comes to taxes, why it is considered taxable income when I paid income taxes on that money before I put it into an IRA?
A: IRA rules are tricky because there are really two types of IRAs. With the traditional IRA, you put in money and get an upfront tax deduction (provided you meet certain income guidelines, and other requirements).
Then, when you take the money out during retirement, you’re taxed on that withdrawal.
The point of having a traditional IRA is, of course that you’ll save for your Golden Years.
And the government gives you a tax break for doing so – in the form of letting your capital gains go untaxed until you start to withdraw money.
As a saver/investor, the hope that the traditional IRA is a good deal based on the assumption that once you are in your post-working years, you’ll be in a lower tax bracket than you were when you were generating an earned income.
But with a ROTH IRA, it works differently. You make contributions and get no upfront tax deduction.
Instead, the money grows in your account and those capital gains aren’t taxed — even once you take them out. So while a traditional IRA gives you an upfront tax break, the ROTH gives you a tax break on the back end.
I suppose the reason your IRA withdrawal, and all such withdrawals, are taxable is because you did get the benefit of having that money grow tax free within the IRA.
In other words, the funds appreciated (or had the potential to appreciate) and collect interest and/or dividends.
Such appreciation is considered capital gains and is taxable under current law.