How Are We Penalized For IRA Account Withdrawal?
Though individual retirement accounts allow you to access your money at any time, you can't always get your money out without penalty. The Internal Revenue Service imposes penalties on early withdrawals to discourage you from using your IRA for anything besides retirement savings. On top of the tax penalties, you're also penalized because you can't contribute extra in future years to make up for the decrease in your contribution caused by the withdrawal.
When Penalties Apply
You are penalized for taking taxable distributions from your IRA before you're eligible to take qualified withdrawals. For traditional IRAs, early withdrawal penalties apply to any distribution taken before you reach 59 1/2 years old. Roth IRAs have a two-fold test for qualified distributions. First, five year must have passed since Jan. 1 of the first tax year you made a contribution. Second, you must be at least 59 1/2, or permanently disabled, or taking out up to $10,000 for a first home.
Taxable Portion Only
The IRS only penalizes you for taxable early distributions. If you've made nondeductible contributions, those come out tax-free. With a traditional IRA, you divide your distributions between the nondeductible contributions and the rest of the account. For example, suppose 19 percent of your traditional IRA value consists of nondeductible contributions. In that case, 19 percent of your withdrawal comes out tax-free, and therefore penalty-free. Roth IRAs order distributions differently. Instead of prorating distributions, you get to take out all your contributions before you touch any earnings. Since all Roth IRA contributions are nondeductible, you won't pay any taxes and penalties on a non-qualified withdrawal until you've withdrawn all your contributions, and begin withdrawing earnings.
The early withdrawal penalty is 10 percent on top of any income taxes owed on the distribution. For example, if you take a $12,000 early distribution and the entire amount is taxable, you'll owe $1,200 as a penalty on top of the income taxes.
You can't avoid the penalty by claiming a financial hardship, but you don't have to pay the penalty if you qualify for a penalty exemption. Some exceptions, such as suffering a permanent disability or taking a qualified reservist distribution, exempt the entire distribution from the penalty. Others, such as for medical insurance premiums while unemployed or higher education expenses, apply to a specific dollar amount. Suppose that you take out a $12,000 taxable IRA early withdrawal. If you had a $5,000 higher education exemption, you'd only owe $700 in penalties, which is 10 percent of the $7,000 balance of the withdrawal. These penalty exceptions don't get you out of the taxes on an early distribution.
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."