IRA Early Withdrawal Penalty – How To Avoid It

IRA Early Withdrawal Penalty - How To Avoid It

IRA Early Withdrawal Penalty – How To Avoid It

The IRA early withdrawal penalty is not always always top of mind for IRA owners. Retirement accounts have special advantages when compared to traditional investment accounts. For example, with an IRA, the account owner incurs no annual tax liability resulting from interest, dividends, and capital gains. As long as there are no withdrawals (distributions) from the IRA, the account owner receives no 1099 tax form.

This tax deferral allows the earnings within the account to grow free from annual taxes until you actually need the funds in retirement. This favorable tax treatment of IRAs is designed to provide an incentive to invest for your retirement.

When you withdraw from an IRA, the amount is included in your taxable income. However, if you’re under age 59 1/2 and you take a withdrawal from an IRA, you should plan on paying the dreaded 10% early distribution penalty in addition to your ordinary income taxes.

For example, let’s assume you’re 45 and your tax rate is 28%. If you take $10,000 from your IRA, you would owe income tax of $2,800 and an additional penalty for early distribution of $1,000. As a result, this early withdrawal of $10,000 cost you $3,800 and that doesn’t even include taxes your state may impose.

Fortunately, there are some exceptions to this 10% penalty which can help soften the blow of taking an early distribution. Please note, this is general in nature and should not be relied upon alone in determining whether you’re eligible for the exception.

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Avoiding The IRA Early Withdrawal Penalty

Avoiding the IRA early withdrawal penalty:

Medical expenses: This applies when unreimbursed medical expenses are in excess of 10% of your adjusted gross income or AGI.

Medical insurance: If you’ve lost your job and have received unemployment compensation for 12 consecutive weeks, amounts you pay for medical insurance for yourself, your spouse, and your dependents can be exempt from the 10% penalty.

Disabled: When you can provide proof that you have become disabled and that the condition is expected to be long or permanent, the early distribution penalty will not apply.

Distributions to a beneficiary or estate due to an IRA owner’s death: Your IRA won’t be subject to a penalty for early distribution if you pass away and your beneficiary receives the funds.

Substantially equal payments: You may elect to receive “substantially equal” payments based on your life expectancy. This is sometimes referred to as taking payments in the form of an annuity.

Higher education expenses: These expenses must be considered “qualified higher education expenses” and the education must be for you, your spouse, children or grandchildren.

Qualified reservist distributions: If you are a member of the military reserves, distributions taken during active duty may avoid the 10% penalty.

Qualified first-time home buyer: If you buy, build, or rebuild a first home, up to $10,000 may be exempt from the 10% early distribution penalty.

Can I take money out of my IRA while working?

The short answer to this question is “yes.” You can take withdrawals from your IRA at any time. But there is catch. Assuming all of the contributions you made were tax deductible, the withdrawals would be taxable as ordinary income. If you are under age 59 ½ you would likely be subject to the IRA early withdrawal penalty from the IRS. When added together, the taxes and penalties can take a huge bite out of your IRA.

There is also a way the IRS allows you to take substantially equal periodic payments which can qualify as an exception to the early withdrawal rules.
Just because you can take money out of an IRA, doesn’t mean you should. For many people, it is an easy place to look when funds are needed. It’s almost too easy to withdraw from an IRA and it can lead to less than optimal financial decisions.

How can you borrow from a Roth IRA?

Contrary to popular belief, there is no “borrowing” from Roth IRAs or Traditional IRAs. There are only distributions. “Borrowing” from a Roth IRA or Traditional IRA is a misconception likely due to the ability to borrow from some 401k plans. This is accomplished via a 401k loan. I published an article and video about 401k loans called 401k Loan – 3 Reasons Not To Borrow that goes into more detail.

With regard to Roth IRA distributions, there are ways to access the funds, but it’s not borrowing. Borrowing implies that you can pay it back. You can’t pay back distributions taken from Roth IRAs or Traditional IRAs. There is an exception for distributions from an IRA that are paid back within 60 days. However, that is a totally different subject and it is also a commonly misunderstood rule.

Roth IRA withdrawals (distributions) of principal are tax and penalty free. The reason is that contributions are made with after tax dollars. The IRS has already taken their bite with regard to the principal (what you contributed). The earnings are a different story. While there can be exceptions, early withdrawals can be subject to taxes and penalties that are attributable to earnings (not principal). If you’re looking to take a withdrawal from the Roth IRA due to education, first time home purchase, or to help with a disability, you should definitely read up on the exceptions.

Why is my IRA withdrawal counted as income?

When you invest in a Traditional IRA, the assumption is that you deducted the contributions from income. As a result, withdrawals from Traditional IRAs are 100% taxable as income (contributions and earnings). The rationale for this is that those funds were never taxed. If you, in fact, deducted the contributions you made, it would be correct that you would be taxed on the full withdrawal. If you didn’t deduct the contributions from your taxable income, you made a “non-deductible” IRA contribution. In this scenario, you would be taxed on the earnings.

IRA early withdrawal penalty

Taking an early distribution from an IRA is huge financial decision with potentially serious consequences. More detail on this subject can be found at the IRS website. While retirement accounts should not be used as piggy banks, life has a way of throwing us curve balls. If you’ve found yourself in a bind and withdrawing early from your IRA is the only option, proceed with caution. There are pitfalls in each of the situations listed above. If you plan taking an early distribution, be sure to consult your financial professional or tax advisor.

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