Individual Retirement Arrangements offer a range of tax benefits for retirement savings. However, when you take the distributions, the Internal Revenue Service wants to know about it -- even if these payouts are not taxable. The taxes and penalties on distributions depend on the type of IRA from which you're taking the distribution: either a pretax IRA, such as a traditional, savings incentive match plan for employees, or simplified employee pension IRA, or a Roth, or after-tax, IRA.
Distributions from pretax IRAs are fully taxable unless you've made nondeductible contributions to the account. If you have made nondeductible contributions, your distribution splits between tax-free nondeductible contributions and taxable deductible contributions and earnings. For example, if 40 percent of your IRA value comes from nondeductible contributions and you take a $10,000 distribution, the $4,000 of your contribution that comes from the nondeductible contributions is tax-free while the remaining $6,000 is taxable.
Qualified Roth IRA distributions aren't included in your taxable income. To qualify, the distribution has to happen after you've had the account for five years and you must be 59 1/2, permanently disabled, or taking out no more than $10,000 to buy your first home. If you take a nonqualified distribution, your contributions come out tax-free and you get to take out all your contributions first. However, after you've removed all the contributions, your earning are taxed.
Early Withdrawal Penalties
Generally, if you take a nonqualified IRA withdrawal, the taxable portion of the distribution gets hit with a 10 percent additional tax penalty. This penalty does not apply to any nontaxable early distributions, such as if you only take out contributions from a Roth IRA. However, this penalty increases to 25 percent for Savings Incentive Match PLan for Employees IRA distributions if the early withdrawal is taken before you've had the SIMPLE IRA for less than two years since your employer's first contribution.
Tax Penalty Exceptions
There's no such thing as a generic "hardship withdrawal" exception, but you can avoid the additional tax penalties on early distributions if you meet one of the specific exceptions. For example, you can exempt your entire distribution from the penalty if you suffer a permanent disability or the IRS levies your IRA. The portion of the IRA distribution used for higher education expenses, medical insurance premiums while unemployed, up to $10,000 for a first home, or for medical expenses in excess of a specified percentage of your adjusted gross income, is also exempted from the penalty.
- tax forms image by Chad McDermott from Fotolia.com