Understanding the IRA withdrawal penalty and how to avoid it

What is an IRA withdrawal penalty?

An IRA withdrawal penalty occurs when the IRS assesses a fee on individuals for violating certain regulations when withdrawing from an IRA. There are different IRA withdrawal rules that might apply, depending on your age.

If you are younger than age 59 1/2, you will be assessed a 10 percent early distribution penalty when removing money from an IRA unless you meet certain exceptions. If you are age 70 1/2 or older, you may face an RMD penalty if you fail to take the minimum required distributions that is assessed at 50 percent of the amount that you should have withdrawn. Fortunately, there are things that you can do to avoid these penalties.

Statistics on IRA withdrawals

The IRS reports that slightly more than 13 million people made contributions to some type of IRA in 2015, which is the latest year for which the agency has reported data. The individuals made total contributions during that year of almost $64 billion. Almost 19 million taxpayers made withdrawals from IRAs during the year of almost $295 billion.

As the baby boomers age, the amount of money that will be withdrawn should continue to increase over the next couple of decades. It will be important for older adults to understand their required minimum distributions so that they can avoid being assessed penalties for failing to take their RMDs. Younger people should also be aware of the early withdrawal penalty so that they can likewise avoid it.

What is the IRA withdrawal penalty?

Different types of IRAs

An IRA stands for an individual retirement arrangement or an individual retirement account. It is a tax-advantaged retirement savings vehicle that allows your contributions to grow tax-free until retirement. There are several different types of IRAs, including the following:

  • Traditional IRA
  • Roth IRA

Traditional IRAs can be opened by individuals. The contributions go in pre-tax, allowing them to grow tax-free until they are withdrawn. People then pay taxes when they take out the money. A Roth IRA has contributions on an after-tax basis. When they money is withdrawn after retirement, the owners will not have to pay taxes. An early distribution from a Roth IRA occurs when you take out any of your earnings before you reach age 59 1/2.

SIMPLE IRAs are employer-sponsored retirement plans set up to benefit employees. Contributions go in pre-tax, and the distributions are taxed at the time of withdrawal. SEP IRAs are another type of employer-sponsored IRA. With these IRAs, all of the contributions are made by the employer. It is the account owners that will be taxed at the time they make the withdrawals.

Details on IRAs

Each type of IRA has different features and advantages. A traditional IRA has pre-tax contributions, and the contributions that are made may be deductible on the income tax forms during the year in which they are made. IRAs have annual contribution limits of $6,000 for people who are younger than age 50 and of $7,000 for people who are older than age 50.

Account owners will be taxed at their ordinary income tax rates when removing money from an IRA. If they are younger than age 59 1/2 when withdrawing from an IRA, the owners will be assessed a 10 percent early penalty unless an exception applies.

People who own IRAs must take RMDs beginning on April 1 following when they turn age 70 1/2. If they fail to take the required distributions, they will face a 50 percent penalty on the amount that they should have taken.

Roth IRAs are different. While they have the same annual contribution limits as traditional IRAs, they are made on an after-tax basis and are not deductible on your income taxes. There are different Roth IRA withdrawal rules. If your Roth IRA has been open for at least five years, you are able to withdraw your contributions at any time. However, you cannot withdraw your earnings.

When withdrawing from an IRA that is a Roth account before you reach age 59 1/2, it is important for you to make certain not to take out any earnings or you will have to pay a penalty of 10 percent. There are some exceptions to the Roth IRA early withdrawal penalty, including the following:

  • Disability of the account holder
  • Death of the owner
  • Distributions made under a qualified domestic relations order to divide the IRA in a divorce
  • Payment for qualified higher education expenses
  • Series of substantially equal payments
  • Up to $10,000 for a first-time home purchase
  • Payment for unreimbursed medical expenses that exceed 10 percent of your income
  • To pay health insurance premiums if you have been unemployed for more than 12 consecutive weeks
  • Rollovers if done correctly

SEP IRA is a type of IRA that can be set up by small employers and self-employed people. With this type of IRA, the contributions are made on a pre-tax basis and are deductible. This type of IRA is best for self-employed people or businesses with few employees because the business owner must contribute the same percentage to the employees’ accounts as he or she does to his or her own account.

The contribution limits are higher for SEP IRAs. Employers may contribute up to 25 percent of their earnings to a SEP IRA or up to a maximum of $56,000, whichever amount is less. A 10 percent early withdrawal penalty applies for withdrawals made before reaching age 59 1/2, unless an exception applies. SEP IRAs also have RMDs beginning after you reach age 70 1/2.

A SIMPLE IRA is another employer-sponsored IRA that can be set up by employers. Employers are not required to make contributions to the accounts, but they can choose to do so. These accounts function in a similar manner as 401(k) plans. The annual contribution limits for employees to SIMPLE IRA accounts is $13,000 if they are younger than age 50 and an additional $3,000 per year if they are older than age 50.

SIMPLE IRAs have an early distribution penalty of 10 percent for people who are younger than age 59 1/2. There are also RMDs beginning after the owners turn age 70 1/2. If they fail to begin withdrawing from an IRA when they are required to do so, they will face a 50 percent penalty on the amount that should have been withdrawn.

IRA withdrawal penalties and distribution

Types of IRA distributions

There are a number of different types of IRA distributions. It is important for you to understand each type so that you can make certain to follow the IRA withdrawal rules and avoid being assessed an IRA withdrawal penalty.

An early withdrawal occurs when withdrawing from an IRA before you reach age 59 1/2. This type of withdrawal will violate the IRA withdrawal rules unless an exception applies. Withdrawing from an IRA in violation of the rules will result in an IRA withdrawal penalty of 10 percent. This penalty is in addition to any taxes that you are assessed. One caveat is that if you withdraw funds from a SIMPLE IRA within two years of your first contribution, the penalty will be increased to 25 percent.

With the exception of Roth IRAs, the other types have required minimum distributions or RMDs that start on April 1 following when you turn age 70 1/2. At that time, you will have to start withdrawing from an IRA at a rate of 4 percent of the total balance each year. The IRA withdrawal penalty for failing to take RMDs is 50 percent of the amount that you should have taken out.

The IRA withdrawal rules allow people to take IRA distributions for hardships. A hardship is defined by the IRS as a heavy and immediate financial need. Under these rules, people who have hardships may withdraw only the amount that they need to satisfy the immediate financial need. Hardship distributions will not result in an IRA withdrawal penalty as long as they are in compliance.

Another type of withdrawal that will not incur a 10 percent penalty is a SEPP. This is a series of substantially equal payments that are distributed on a periodic basis over your life expectancy or over the life expectancy of your beneficiary after your death.

Under the IRA withdrawal rules, no IRA early withdrawal penalty will be assessed when your beneficiaries begin taking distributions from the IRA that they have inherited from you after your death. The rules regarding how they treat an inherited IRA will depend on whether the beneficiary is your spouse or a non-spouse.

Another exception to the IRA withdrawal penalty is when people take an early distribution from their account because of becoming totally and permanently disabled. However, your doctor must certify that your condition is permanent, continuous, or terminal in order to avoid the penalty.

You are also allowed to take an early withdrawal from an IRA to pay for your qualified higher education expenses or the qualified higher education expenses of an immediate family member. Qualified expenses include your tuition, fees, and books but do not include the costs of your room and board under the IRA withdrawal rules. Withdrawals that are made for qualified education expenses will not incur an IRA withdrawal penalty.

IRA withdrawal penalty: How much will it be?

How much will the early distribution penalty be?

The early distribution penalty that you might have to pay under the IRA withdrawal rules depends on the type of account that you have as follows:

  • Traditional IRA early withdrawal penalty of 10 percent
  • Roth IRA withdrawal penalty of 10 percent, but some withdrawals are exempt
  • SEP IRA early withdrawal penalty of 10 percent
  • SIMPLE IRA penalty of 25 percent within the first two years or 10 percent after the first two years

Please consult your own tax or financial advisors before you make any changes or take actions.

Exceptions to early distribution penalties

There are multiple IRA early withdrawal exceptions that will not incur an IRA withdrawal penalty. Under the IRA withdrawal rules, you will not pay a penalty after you reach age 59 1/2 when you take distributions. If you participate in a SIMPLE IRA that has auto enrollment features, you will not be penalized for a permissive early withdrawal.

People who qualify as first-time homebuyers are allowed to have an early withdrawal from an IRA up to $10,000 towards the purchase of their homes. You can qualify as a first-time homebuyer as long as you have not held an interest in any home during the two years prior to the date of your home purchase. The money must be spent on the acquisition of your new home within 120 days of when you make the early withdrawal from an IRA.

If you owe substantial back taxes, the IRS may levy your IRA. You will not be assessed a Roth IRA withdrawal penalty or a traditional IRA penalty for funds that are levied by the IRS.

There are also IRA early withdrawal exceptions to the penalty for medical expenses. If the amount of your unreimbursed medical expenses are more than 10 percent of your income, you can withdraw money to pay for them.

You are also able to take an early distribution from an IRA to pay for your health insurance premiums when you are unemployed. To take an early distribution from an IRA to pay the cost of your health insurance, you must be unemployed for at least 12 consecutive weeks.

You can take an early distribution from a Roth IRA or another type of retirement savings account if you are a qualified military reservist who is called to active duty. In this case, you will not be assessed a Roth IRA withdrawal penalty.

You can avoid a traditional or Roth IRA withdrawal penalty if you withdraw contributions and return them by the extended due date of return. You must return the contributions within 60 days or roll them over into a new IRA to avoid the penalty.

Rollovers can be completed without incurring a penalty. This includes in-plan Roth rollovers and eligible distributions that are contributed to another IRA plan or IRA within 60 days.

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