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Individual retirement accounts are designed for retirement savings, but that doesn't mean you're prohibited from taking money out before you stop working. To prevent people from abusing IRAs, the Internal Revenue Service tacks on extra tax penalties for early withdrawals, unless an exception applies.
Early Withdrawal Defined
An early withdrawal from an IRA refers to any distribution that doesn't meet the criteria to be a qualified distribution. For traditional IRAs, qualified distributions are any distribution taken after you turn 59-1/2-years-old. If you're younger than 59 1/2 and you take money out of your traditional IRA, you're taking an early distribution. For Roth IRAs, qualified distributions also require that you have a Roth IRA that's at least five years old. The five years count from Jan. 1 of the first tax year you made a contribution.
When you take an early withdrawal, you have to pay an extra 10 percent penalty on the taxable portion of your distribution. Because you received a tax deduction for contributing to your traditional IRA, your distributions are all taxable income. So, the penalty applies to all of your distributions -- on top the ordinary income taxes. For example, if you take out $6,000 and you're in the 25 percent tax bracket, you'll pay $1,500 in taxes and $600 in penalties. If you made nondeductible contributions to the traditional IRA, a fraction of your withdrawal comes out tax-free, and therefore penalty-free. For example, say your traditional IRA has $8,000 of nondeductible contributions and is worth $32,000. Because your nondeductible contributions account for 25 percent of the account value, 25 percent of your early withdrawal comes out tax-free and penalty-free.
Early withdrawals from Roth IRAs are a little more complicated. You get to take out your contributions first without being taxed or penalized because you didn't get to deduct them. Only after you've taken out all your contributions do you touch the earnings, which are taxed and liable for the 10 percent early withdrawal penalty. For example, if your Roth IRA contains $10,000 of contributions and you take out that $10,000, your distribution of these contributions doesn't incur any taxes or penalties. But, if you take out $12,000, the first $10,000 is tax-free and penalty-free, while the last $2,000 is taxable income on which you are charged the 10 percent penalty.
The IRS waives the early withdrawal penalty -- but not any ordinary income taxes -- on IRA early withdrawals if you qualify for an exception. A permanent disability, taking distributions as a beneficiary, or qualified reservist distribution avoids the penalty on the entire distributions. Other exceptions, as of 2013, such as paying for higher education expenses, medical expenses exceeding 10 percent of your adjusted gross income, medical insurance premiums when you lose your job, distributions due to an IRS levy of the plan, distributions taken in the form of an annuity, or up to $10,000 for a first home purchase only exempt that portion of your withdrawal.
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