How the IRA Early Distribution Penalty Works
And why you should avoid tapping retirement money early
You pay an IRA early withdrawal penalty when you take money out of your IRA before you reach age 59 ½. The good news is that transferring an IRA from one account to another is not considered a distribution, so you are free to change financial institutions at any time without worry about a penalty tax.
If you think you need money, and your IRA is the only place you can get it, make sure you know how the penalty tax works before you decide to cash in part of your IRA.
How does the IRA early withdrawal penalty work? Here’s an example.
Suppose you are age 54 and you take $10,000 from your traditional IRA.
- The $10,000 shows up as income on the first page of your tax return (on line 15a and 15b on a regular 1040 form.)
- This income is included along with your other sources of income to determine the total amount of tax owed for the year.
- The amount of tax owed on the $10,000 will depend on your income tax rate, which is determined by your total income and deductions.
- In addition to the tax on the $10,000 early withdrawal, a 10% penalty tax is assessed on the withdrawal.
- In this scenario, that would be an additional $1,000 of tax owed in addition to your ordinary income taxes.
If you had at least $1,000 more in taxes withheld during the year than what you would need to cover your normal tax bill, then, despite the IRA early withdrawal, no additional taxes would be owed.
Meaning if you hadn't taken the early IRA withdrawal, you would have received at least $1,000 refund. Because of the penalty tax, you don't get the refund.
If you didn't pay in enough during the year, you would owe at tax time, and you could also be hit with an additional penalty to the IRS for underpayment of taxes.
To avoid this, when you take your IRA distribution it is best to have taxes withheld right from the distribution. So if you were taking a $10,000 early distribution, and had 30% in taxes withheld, you would receive a check for $7,000, and $3,000 would get sent right to the IRS for taxes.
Avoiding the Penalty Tax
If you are using an early IRA distribution to pay off debts, think again. Retirement accounts may provide some forms of creditor protection. Learn more in Before You Cash Out a 401(k). Many of the creditor protection rules that apply to 401(k)s also apply to IRAs.
It is tough to save enough to replenish an account after an early withdrawal. You should think of your IRA money as your nest egg. Do everything you can to avoid an early withdrawal. If you have to take funds from your IRA, see if you can qualify for an exception to the penalty tax.
The penalty tax above also applies to early withdrawals taken from 401(k) accounts.
Once you reach age 59 1/2 (or age 55 in some cases for a 401(k) plan), the penalty tax will no longer apply on withdrawals. At that point, any withdrawal becomes ordinary taxable income to you. I cover those rules in Taxes on Normal IRA Withdrawals.
The penalty and taxes may not seem that steep at first, but remember that same $11,000 today would be worth $26,000 fifteen years down the road if your investments earned 6% returns annually.
Ask yourself, is this my best option?