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 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. Special tax treatment of IRAs provides an incentive to invest for retirement.

IRA withdrawals are 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. This is in addition to your ordinary income taxes.

For example, let's assume you're 45 and your tax rate is 24%. If you take $10,000 from your IRA, you would owe income tax of $2,400 and an additional penalty for early distribution of $1,000. As a result, this early withdrawal of $10,000 cost you $3,400 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 article is general in nature. Be sure to consult a tax professional to determine whether you're eligible for these exceptions.

Medical expenses

This applies when unreimbursed medical expenses are in excess of 10% of your adjusted gross income or AGI. You must pay the expenses in the same calendar year as the IRA distribution.

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

The IRA early withdrawal penalty will not apply if you become disabled and the disability is expected to be long or permanent. It is important to note that proving permanent disability can be extremely challenging.

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Distributions to a beneficiary 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. Additionally, your beneficiaries will be subject to new distribution rules set forth in The SECURE Act beginning in 2020. If you inherited an IRA from anyone other than your spouse prior to 2020, take note. Required Minimum Distributions (RMDs) are required during your lifetime. These RMDs begin not matter your age. While the RMDs are not subject to early withdrawal penalties, they are included in your taxable income

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. You must keep the schedule of payments for at least 5 years or until you attain age 59 1/2. Proceed with caution.

Higher education expenses

These expenses must be considered “qualified higher education expenses” and the education must be for you, your spouse, children or grandchildren. Remember, these withdrawals are NOT tax free. Distributions are still taxable.

Qualified reservist distributions

Distributions taken during active duty may avoid the 10% penalty for members of the military reserves.

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.

Avoiding The IRA Early Withdrawal 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. IRAs are an easy place to look for funds. It’s almost too easy to withdraw from an IRA. The result leads 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. IRA distributions paid back within 60 days are an exception. However, that is a totally different subject. The 60 day rule is commonly misunderstood.

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?

Investing in a Traditional IRA assumes contributions are tax deductible. As a result, withdrawals from Traditional IRAs are 100% taxable as income (contributions and earnings). 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. Therefore, earnings are taxable.

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. Retirement accounts are not piggy banks. However, 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. The situations listed above have pitfalls. If you plan on taking an early distribution, be sure to consult your financial professional or tax advisor.

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