The California Penalty for Early IRA Distribution
To paraphrase Charles Dickens, California living can be both the best (beaches, abundant sunshine, inspiring mountains, and deserts) and the worst (rising ocean levels, drought, homelessness and skyrocketing rents) of times. Some Californians might add to that list of worsts, the state's unique penalty for early withdrawal from a qualified retirement plan, including both traditional IRAs and Roth IRAs. California is the only state to add a state penalty to what is already a Federal double-whammy.
You'll pay up to 13 percent income tax, depending on your tax bracket, if you take an early withdrawal from your IRA, and the double-whammy penalty tacks on an additional 2.5 percent for most types of IRAs.
Simple IRAs carry a higher penalty for early distributions -- 6 percent of the amount of withdrawn funds is assessed if you withdraw funds within two years of establishing your Simple IRA account.
Other States and Territories
In the other 49 states and in U.S. territories, if you withdraw funds from either a traditional IRA or a Roth IRA before you're 59 1/2, the IRS considers the withdrawal "unqualified," and tacks on a 10 percent penalty. This is in addition to your having to pay income tax on the amount distributed.
The benefit you enjoy from a traditional IRA is that the money you've put in, untaxed, grows over time. Growth rates are around 10 percent annually if you put it in an S&P 500 fund with low management fees. Although you're taxed when you withdraw it – normally in retirement – the money has grown faster than if you'd paid taxes on it when earned and had contributed only the untaxed remainder, a smaller amount, to your IRA.
Exploring Mandatory Tax Payments
The reason for the mandatory tax payment when you withdraw from a traditional IRA is straightforward: when you contributed money to your IRA, you weren't taxed on it; instead, you're taxed upon withdrawal. Early Roth IRA withdrawals aren't taxed because you paid the income taxes due when you contributed. You are, however, penalized the same 10 percent for an unqualified withdrawal from a Roth as from a traditional IRA.
The reason for the 10 percent Federal penalty for unqualified early withdrawals, whether from a Roth or a traditional IRA, isn't quite so straightforward, but it's understandable: the Federal Government has always encouraged savings of every kind, but especially retirement savings, which is why they've given IRAs a significant tax advantage. The 10 percent penalty for an unqualified withdrawal is a deliberate discouragement – an additional motivation to keep your savings in your IRA until retirement.
California's Penalty on Unqualified IRA Withdrawals
California is a high income-tax state. Defenders of its tax rates point out that California provides benefits that low income-tax states do not. Critics may prefer to forego those benefits in exchange for lower state taxes, and in fact, some retirees move to lower income-tax states to avoid them. Whatever your personal preference, if you live in California you're probably paying state income taxes in an amount ranging from 1 percent to 13 percent of your federally taxable income.
California's tax exemption for IRA contributions is essentially the same as the Federal government's. You'll, therefore, pay the State of California income tax due on the amount when you withdraw it for the same reason: when you contributed to the IRA, you didn't pay the state tax, so you pay it upon withdrawal.
Comparing IRS Withdrawal Rules
What's different about California's treatment of early IRS withdrawals compared to other states is that California not only taxes the early withdrawal but _penalize_s it.
The penalty in most cases is an additional 2.5 percent of the amount withdrawn. If your IRA is a Simple IRA, a special kind of IRA for beginning savers working for small firms, the penalty for withdrawal within two years of setting up your Simple Ira account is 6 percent.
When filing your California state income tax after an unqualified IRA withdrawal, you'll need to fill out the required California State Form FTB 3805P.
I am a retired Registered Investment Advisor with 12 years experience as head of an investment management firm. I also have a Ph.D. in English and have written more than 4,000 articles for regional and national publications.