Final answer:
A withdrawal or distribution from a Traditional IRA is taxed as income at the time of withdrawal, since the account is tax-deferred. Contributions to Traditional IRAs may initially reduce taxable income, while Roth IRAs provide tax-free growth, as they comprise after-tax contributions.
Step-by-step explanation:
When a taxpayer takes money out of a Traditional IRA, it is commonly referred to as a withdrawal or distribution. This account is viewed as a tax-deferred savings vehicle, meaning that while funds within a Traditional IRA grow without being taxed on their gains year-to-year, they are taxed as income at the time of withdrawal.
The funds contributed to a Traditional IRA typically come from pretax income, which can reduce the taxpayer's taxable income in the year of contribution, potentially leading to immediate tax savings.
Roth IRAs, on the other hand, are comprised of after-tax contributions, indicating that the money placed into these accounts have already been subject to income tax.
Therefore, when a distribution is taken from a Roth IRA, the funds, including the earnings, are generally not subject to further taxes, providing tax-free growth. The incentive with Roth IRAs is that if you expect to be in a higher tax bracket at retirement, you would owe no tax at all on the earnings when you withdraw.
Additionally, there are annual contribution limits and deadlines for both IRAs which must be observed in order to maintain their tax-advantaged status.