How the IRA Early Distribution Penalty Works
Early IRA Withdrawal and How the Early Distribution Penalty Works
You pay an IRA early withdrawal penalty when you take money out of your IRA before you reach age 59.5. 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 worrying about a penalty tax. If you think you need money, you're younger than age 59.5, and your IRA is the only place you can get the funds, make sure you know how the penalty tax works before you decide to cash in part of your IRA.
How the IRA Early Withdrawal Penalty Works
Here's an example to show how the early withdrawal penalty works. Suppose you are age 54 and you take $10,000 from your traditional IRA. The penalty would be calculated as follows:
- The $10,000 is considered income on your tax return.
- 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 the increase in your ordinary income taxes due to the additional $10,000 in income.
If you didn't pay in enough during the year, you could 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.
Ask Your Financial Institution to Withhold Your Taxes
Your financial institution may be able to estimate the amount of taxes you will owe. If you're concerned about tax consequences, ask your financial institution to withhold for federal taxes plus another 10% for the early withdrawal penalty.
Avoiding the Penalty Tax
If you are using an early IRA distribution to pay off debts and avoid potential judgments, think again. Retirement accounts may provide some forms of creditor protection. 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 59.5 (or age 55 in some cases for a 401(k) plan), the penalty tax will no longer apply to withdrawals. At that point, any withdrawal becomes ordinary taxable income to you.
The penalty and taxes may not seem that steep at first, but remember, that same $11,000 today would be worth $26,000 15 years down the road if your investments earned 6% annually. Ask yourself, is this my best option? Is it worth the steep tax penalty? What other decisions have I made this year that might impact my taxes? In most cases, it's best to leave your IRA alone if at all possible.