Question 2: What is the tax and penalty on the withdrawal of all funds from both a conventional deductible IRA and a Roth IRA prior to age 59 ½ five years after an initial contribution of $3,000 assuming a 6 percent return on invested assets, and a marginal tax rate of 20 percent?
Answer: The entire distribution from the conventional IRA is subject to tax and penalty while only the investment income portion of the distribution from the Roth IRA is subject to tax and penalty. The calculations below assume a tax rate of 20 percent and a penalty rate of 10 percent on the relevant amount.
- Total funds in both IRAs after five years is $4,015.
- The penalty and tax on the conventional IRA is $1,204.40.
- The penalty and tax on the Roth IRA is $304.40
Also, note the owner of the Roth IRA could have limited her withdrawal to $3,000, kept the investment return in the Roth and paid no penalty and tax.
The lack of penalty or tax on the distribution of the initial contribution makes the Roth IRA the better choice for people starting their careers or for people with limited liquidity. For more information on the choice between a Roth IRA and a conventional IRA look at the first two financial tips here.