The individual retirement arrangement was created to encourage retirement saving among working Americans. Both the traditional IRA and the Roth IRA offer tax advantages, and the rules surrounding withdrawals vary by type of account. Some early withdrawals are especially expensive.
Traditional IRA Withdrawals
A key point to keep in mind is that all traditional IRA distributions are subject to ordinary income tax. You are taxed at your usual income tax rate unless the withdrawal has increased your adjusted gross income such that you are pushed into a higher tax bracket. For this reason alone, it is ideal to consider your IRA withdrawals carefully, even consulting a tax or financial professional for advice before making any moves.
Early Withdrawal From a Traditional IRA
With few exceptions, you must have reached the age of 59 1/2 to take money out of a traditional IRA penalty-free. Most early withdrawals trigger a 10 percent penalty in addition to the ordinary income tax that is always assessed. Thus, if you take $20,000 out of your traditional IRA at age 40, you will pay both income tax and a $2,000 penalty. You pay the tax and penalty when you file your taxes for the year. Depending on your tax bracket, you could lose up to 45 percent of the distributed amount.
The Internal Revenue Service lets you remove your ordinary contributions from a Roth IRA for any reason at any time without tax or penalty. You may consider that you'll lose nothing on withdrawals of principal. But the Roth IRA is intended to fund your retirement. What you will lose in fact are the earnings that would have accumulated on those dollars if they had remained in the account.
Earnings on Roth IRA contributions are subject to a 10 percent penalty and ordinary income tax unless both of the following conditions are met: your account has been open and funded for at least five years, and you have turned 59 1/2. If you are at least 59 1/2 but the account has been open for less than five years, you will incur only ordinary income tax on the withdrawal. Note that there are certain exceptions to the early-withdrawal penalty, such as distributions that are used to pay for a first-time home purchase or for certain unreimbursed medical expenses.