Unexpected expenses may compel you to tap your individual retirement account ahead of schedule. And with most plans, the government will impose a 10% penalty if you withdraw funds before you reach age 59 1/2. Many people work with financial advisors to help manage their retirement plans and grow their nest eggs. Let’s take a look at a few instances where you can make a penalty-free IRA withdrawal before retiring.
Why the Early Withdrawal Penalty Exists
The 10% early withdrawal penalty exists to deter savers from draining their nest eggs prematurely. It also limits the number of retirees dependent on government assistance down the line. Since most American families do not have adequate savings to retire, the penalty could help millions from endangering their golden years.
Social Security benefits provide one source of income in retirement, but those payments rarely cover all of a retirees’ expenses – especially as healthcare costs climb. The early withdrawal penalty can help workers save enough to cover any gap between basic living expenses and Social Security benefits.
When Does the 10% Early Withdrawal Penalty Kick In?
Generally, the 10% penalty applies to any IRA withdrawals made prior to age 59 1/2. This is true for traditional IRAs, as well as SEP and SIMPLE IRAs. For Roth IRAs, you’re free to withdraw your original contributions at any time without a penalty. Early withdrawals of earnings, however, may trigger the 10% penalty. In other words, you can take out only what you put in.
The penalty is not the only cost you’ll face, though. A traditional IRA withdrawal is also subject to ordinary income tax. Early withdrawals of earnings from a Roth IRA may also be subject to regular income tax if you’ve had your IRA for less than five years.
How to Make a Penalty-Free IRA Withdrawal
The IRS allows penalty-free IRA withdrawals in several scenarios. With most traditional and Roth IRAs, penalty-free withdrawals are allowed before age 59 1/2 when:
- You become totally and permanently disabled
- The IRA owner passes away
- The IRS has imposed a levy on your IRA for an unpaid tax debt
You can also make penalty-free IRA withdrawals if you are:
- A military reservist called to active duty
- Funding qualified education expenses
- Purchasing your first home
- Paying health insurance premiums out of pocket during a period of unemployment
- Covering unreimbursed medical expenses exceeding 10% of your adjusted gross income
- Receiving substantially equal periodic payments as a form of income
- Rolling money over from your IRA to another retirement plan within 60 days
When a Roth IRA is inherited on the death of the owner, money can be withdrawn tax-free. But, the IRA still has to meet the five-year holding period to avoid the early withdrawal penalty. Funds held in a Roth IRA must be fully withdrawn by the end of the fifth year after the account owner’s death if the person inheriting the account isn’t their spouse.
Reporting Early IRA Withdrawals on Your Taxes
If you’re taking money from an IRA prior to retirement, you’re required to give the IRS a heads-up. Early IRA withdrawals and early withdrawals from other qualified retirement plans are reported on IRS Form 5329.
Completing this form can help you determine whether you owe an early withdrawal penalty on an IRA withdrawal and whether you’re responsible for paying income taxes on the distribution.
When You’re Required to Withdraw Money From an IRA
While the early withdrawal penalty is something to avoid whenever possible, that’s not the only IRA penalty to be aware of. For traditional IRAs, you must also consider required minimum distributions. Determined based on your life expectancy and account balance, you must begin taking withdrawals in the year after you turn 72.
If you fail to take a required minimum distribution on schedule, the IRS can attach a stiff tax penalty. The penalty is currently 50% of the amount you were required to withdraw. And of course, you’d still owe ordinary income tax on traditional IRA withdrawals once you take a distribution.
The advantage of Roth IRAs is that the required minimum distribution rule doesn’t apply. You can leave your money in your account until you need to make a withdrawal, regardless of age.
Your IRA is a powerful tool for retirement savings, but sometimes you need access to that money before retirement rolls around. If you’re considering an early IRA withdrawal, get to know the penalty exceptions. And if a penalty applies, make sure you plan ahead so you’re not hit with an unexpectedly high tax bill after filing your return.
Tips for Making the Most of an IRA
- If you have yet to open an IRA, you may be wondering whether a traditional or Roth account is best for you. While both have tax advantages, one may serve your financial goals and needs better than the other. Talking with a financial advisor can help you decide which type of IRA is best. They can also develop a full financial plan that strengthens your retirement portfolio. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Review your IRA contributions annually. If possible, max out those contributions each year to help grow your savings faster. And remember, once you reach your 50th birthday you can make additional catch-up contributions to your account above the regular annual contribution limit.
- If you want to know how much you will need to retire comfortably, SmartAsset’s retirement calculator can help you figure out how much you will need to reach your retirement goals.
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