What are the Downsides of IRA's?

For all their good points, there are some downsides to IRAs, both Traditional and Roth IRAs. First, we will deal with a Traditional IRA. The major issues are limits on when you can take out the money, when you must take the money out and what happens when you die.

The IRS has set very strict limits on when you can take out your money and what happens if you don’t take your money out fast enough. Once you contribute to an IRA, you can’t touch the money until you 59 ½. There are some exceptions, but for the most part, if you do take the money out early you not only have to pay tax on the amount withdrawn, but a 10% penalty on top of it. For example, if you withdraw $10,000 from your IRA and you are in the 15% tax bracket, you will have to pay $1,500 in taxes (15% of $10,000), plus an additional $1,000 penalty, for a total tax of $2,500.

On the other side, you must start to take out the money in the year you turn 70 ½. This is referred to as the Required Minimum Distribution, or RMD. If you fail to take out enough, the IRS will penalize you 50% of the amount you did not withdraw. As an example, if your RMD was $20,000 and you only took out $12,000. You would need to pay a 50% penalty on the $8,000 you did not take out, or $4,000 (50% of $8,000).

When you die and give a non-IRA to your heir, the heir receives the amount in account free of taxes. However, with an IRA, your heir will owe taxes on the money in the account. Recent tax changes allow your heir to stretch the payments out over a long period of time, but taxes still must be paid on the withdrawals.

Now let’s turn to the Roth IRA. With a Roth IRA, you can take out money you contributed after the account has been open for 5 years. However, you can’t take out the earnings on the account until you are 59 ½. If you do take out the earnings, you need to pay a 10% penalty, just like in a Traditional IRA. Unlike a Traditional IRA, there is no required minimum distribution, so you won’t need to take out money in your retirement if you don’t need it. Since money in the account is already tax free, your heirs will not owe taxes on it when you die.