The main purpose of an Individual Retirement Account is to provide tax-advantaged retirement savings. However, If you find yourself in a hole and need to use that money, it is available to you -- with a catch. All distributions from a traditional IRA will be taxed as regular income unless some of your contribution was after-tax. In addition, if you liquidate before reaching age 59 1/2, you will have to pay an additional 10 percent penalty with certain exceptions. For a Roth IRA, you can always withdraw your own contributions tax and penalty-free, and your entire distribution will be tax-free if you've reached age 59 1/2 and had the plan for five years. Otherwise, any amounts attributable to investment income will be taxed and penalized.
Evaluate whether you need to liquidate the entire IRA. Many of the costs you might use your IRA to pay are considered allowable early distributions. This means you will pay tax on previously untaxed amounts, but you won't pay the 10 percent penalty. These include distributions for qualified higher education costs for you or a dependent, health insurance premiums if you are unemployed, nonreimbursed medical expenses that exceed a certain threshold and the cost of a first home for you, your child, grandchild or parent up to $10,000.Step 2
Contact your plan custodian if you determine that you absolutely must liquidate your IRA. Your custodian will likely require that you complete certain paperwork, including how you would like the funds distributed -- e.g., check or direct deposit to your bank account -- and whether you want taxes withheld. By default, your custodian will have to withhold 10 percent of the distribution, but you can arrange to have more withheld to cover taxes you might owe. You might also be able to arrange for state tax withholding if your state has an income tax and if your state and custodian allow for it.Step 3
Alert your plan custodian if you have not received a form 1099-R showing the distribution by the end of February following the year of the IRA liquidation. The amount of a traditional or Roth IRA distribution will show up in Box 1 -- Gross Distribution. Traditional IRA distributions will also be listed in Box 2a. In both cases, "Taxable Amount Not Determined" will be checked in Box 2b. This is because you need to determine the taxable amount when you file your taxes.Step 4
File IRS Form 8606 with your annual income tax filing for the year of the liquidation if it came from a Roth IRA. Also file IRS Form 5329 if the liquidation was an early distribution from a Roth or traditional IRA.
- If you only need the money for a short period of time, consider a rollover. While there is no provision for "borrowing" from an IRA, you can do one indirect rollover per year, but you must redeposit funds in a new IRA account within 60 days of receipt. If you only need a short-term loan, this might be a better way to go.
- Your custodian will likely require a Medallion Signature Guarantee, especially if the distribution is over $100,000. This is available from many financial institutions and is different from notarization.
- The tax consequences, even without a penalty, can be substantial if your IRA is large. Seriously consider if you want to liquidate the entire account.
Nancy Cross is a certified paralegal who has worked as an employee benefits specialist and counseled employees on retirement preparation, including financial and estate planning. In addition to writing and editing, she runs a small business with her husband and is a certified personal trainer with the Aerobics and Fitness Association of America (AFAA).