To discourage using individual retirement accounts for anything besides retirement, the Internal Revenue Service hits early withdrawals with a 10 percent penalty. For traditional IRAs, to avoid the early withdrawal penalty on taxable contributions, you must be 59 1/2 or older at the time of the distribution or qualify for certain exceptions. The IRS makes another exception for nondeductible contributions to a traditional IRA.
Exempt from Penalty
The early withdrawal penalty applies only to the taxable portion of your early withdrawal. Since nondeductible contributions didn't get you a deduction when you made the contribution, you don't have to pay the early withdrawal penalty on that portion of the withdrawal. If your entire withdrawal consists of only nondeductible contributions, you won't owe any early withdrawal penalties.
Traditional Early Withdrawals
If you're taking an early withdrawal from a traditional IRA, you must prorate your distribution between nondeductible contributions and the remainder of the account. To figure the amounts, divide the amount of nondeductible contributions in the account by the total account value when you take the distribution to figure the portion that comes out of nondeductible contributions. Then, multiply the ratio by the amount of the early withdrawal to figure the portion that is tax-free and penalty-free. For example, suppose your traditional IRA has $30,000 of nondeductible contributions and is worth $50,000. Divide $30,000 by $50,000 to get 0.6. Then, if you're taking out $8,000, multiply $8,000 by 0.6 to find that $4,800 comes out tax-free and penalty-free.
Roth Early Withdrawals
Roth early withdrawals are much easier to figure: you get your contributions out first -- tax-free and penalty-free -- before you take out any of your earnings. Since all Roth IRA contributions are nondeductible, you don't have to worry about tracking which contributions you deducted. For example, say your Roth IRA has $30,000 of contributions and is worth $50,000. The first $30,000 of early withdrawals is tax-free and penalty-free.
When you take an early withdrawal that includes nondeductible contributions, either from a traditional IRA or a Roth IRA, you must use Form 8606 when you file your income taxes. The withdrawal of the nondeductible contributions won't be included in your taxable income, and the Form 8606 will show the IRS why you aren't paying any early withdrawal penalties on that portion of the distribution. If you don't have any taxable early withdrawals, you won't have to file Form 5329 to figure the early withdrawal penalty.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."