Individual Retirement Accounts (IRAs) are investment accounts that offer tax advantages when you follow Internal Revenue Service regulations. In addition to restrictions on contributions, the IRS levies taxes on most distributions, and an additional penalty for premature withdrawals. If you take a distribution for an IRS-approved reason, you may be able to avoid the penalty. Although taxes are not technically a penalty for early withdrawal, you should also consider the tax ramifications of any distributions you take.
Early Distribution Penalty
The early distribution penalty on IRA accounts was designed to help prevent investors from raiding their retirement savings prematurely. Thus, if you withdraw from your IRA account before you turn 59 1/2, the IRS will assess a 10 percent penalty on the amount withdrawn. If your IRA is part of a SIMPLE IRA plan that was established by your employer, the penalty can be even more severe. If you are under the age of 59 1/2 and you withdraw from a SIMPLE IRA that was established within the last two years, the IRS penalty jumps to 25 percent. Some states also assess a penalty tax on premature IRA withdrawals.
Taxation
Distributions from all IRA accounts, except for Roth IRAs, are fully taxable at ordinary income rates. This is in addition to the IRS early withdrawal penalty. Thus, if you are in the highest tax bracket and take an early distribution from a traditional IRA, your total cost could reach 45 percent of the amount withdrawn, plus state penalties and taxes. For penalized SIMPLE IRA withdrawals, the total federal cost alone could skyrocket to 60 percent.
Five-Year Holding Period for Roth IRAs
Although most distributions from Roth IRAs are tax-free, if you take a withdrawal within the five-year period starting when you first established the Roth, you will owe a 10 percent penalty. Additionally, the earnings on the distribution will be subject to ordinary income tax.
Penalty Exceptions
Even if you are under the age of 59 1/2, the IRS allows certain exceptions to the 10 percent penalty for early withdrawals. Some of the more commonly-used exceptions are for distributions due to death, disability, higher education expenses, excess medical expenses or the first-time purchase of a home, up to $10,000. Other allowable exceptions include qualified reservist or disaster assistance distributions, IRS levies, and withdrawals taken as a series of substantially equal payments.
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