Do I Need to Claim Earned Interest on My IRA or Annuity?

The type of retirement account you have determines your tax liability

Source: StockMonkeys (Flickr)

The type of annuity or IRA to which you contribute determines the tax treatment of contributions, growth and distributions. Traditional IRAs and the appreciation within them are viewed differently than identical money in a Roth IRA.

The same is true for accumulation and earnings in qualified versus non-qualified annuities. Prior to opening a retirement account or withdrawing money from one, become familiar with the type of account you have and the potential income tax ramifications of your actions.

During the Accumulation Phase

Money in IRAs and annuities is intended for use during retirement. In exchange for taking the initiative to save for later years, the IRS allows you to defer the payment of income taxes on earnings within designated retirement accounts. The growth on money in an IRA or annuity is exempt from federal income tax liability and isn't considered taxable earnings as long as that money remains within the retirement account.

During the Distribution Phase

When you reach age 59 1/2, you may begin taking penalty-free withdrawals from your IRAs and annuities. However, any previously untaxed money you receive as a distribution from such retirement accounts is considered taxable earnings for that year. Distributions from annuities and IRAs are taxed at ordinary rates and must be included in gross income calculations for income tax filing.

Roth IRAs

Roth IRAs present a unique and potentially advantageous opportunity with regard to the taxation of retirement savings. Unlike traditional IRAs and annuities within employer-sponsored retirement plans, Roth IRAs don't result in income tax deductions for contributions. The growth of money in Roth accounts still accumulates without income tax liability and, like their traditional IRA counterparts, must remain untouched until age 59 1/2 to avoid early withdrawal penalties. However, unlike IRAs and qualified annuities, eligible distributions from a Roth are received income tax-free.

Early Withdrawals

Money withdrawn from annuities or IRAs prior to the year you reach age 59 1/2 will likely result in an early withdrawal penalty of 10 percent. This penalty is in addition to any ordinary income taxes that would otherwise be due as a result of the increased earnings stemming from the distribution. Only in certain specific circumstances will the IRS waive the early withdrawal penalty: disability, annuitization, qualified higher education expenses, purchasing your first home or excessive medical expenses.

Article originally published on The Nest (12/09/2012)