What are the Early Withdrawal Penalties for Traditional and Roth IRA Retirement Plans?

Retirement planning involves establishing your retirement income goals and figuring out how you are going to attain those goals. You need to identify different types of income sources, make up a list of expenses, implement a savings plan, and manage assets and risk. To save for retirement, most individuals consider investing in popular investment vehicles such as 401ks and individual retirement accounts (IRAs). These instruments allow investors to grow their money and have certain tax advantages that help build significant retirement corpus over time. 

However, at times, when facing a financial crisis, you may consider making a withdrawal from your retirement account to meet your expenses. This may be ill-advised. If you make an early withdrawal from an IRA, you may incur a penalty. Doing so may also negatively impact your potential earnings in the future. Reach out to a professional financial advisor who can advise you on the implications of making an early withdrawal from your IRA account and how to avoid them.

This article discusses the penalties charged when making an early withdrawal from both traditional and Roth IRAs and how you can avoid them.

Traditional IRAs

What is the penalty for making an early withdrawal from a traditional IRA?

Making an early withdrawal from a traditional IRA is subject to a 10% penalty. The Internal Revenue Service (IRS) levies the penalty which may be in addition to income taxes as well. You can calculate the penalty amount on the withdrawal by multiplying the taxable distribution amount by 10%. For example, if you withdrew $5,000 from your account, you would need to pay a $500 tax penalty which will be treated as your additional income.

Since you make contributions to a traditional IRA from your pre-tax income, the contribution amount is subtracted from your taxable income for the year. This means that you receive an up-front tax break but will have to shell out ensuing taxes on your withdrawals in retirement. Thus, effectively your entire traditional IRA balance is subject to tax. Hence, if you make an early withdrawal before reaching 59.5 years of age, the 10% tax penalty will be applicable to the full amount of the withdrawal.

Are there any exceptions to an early withdrawal penalty from a traditional IRA?

There are certain cases wherein you can make a withdrawal before turning 59.5 and the ensuing penalty for the same may be waived off.

The exceptions are as follows:

1. If you have to pay medical insurance premiums and have been laid off.
2. If you have become permanently disabled.
3. If your distributions are lower than the qualified higher education expenses.
4. If you are buying a home for the first time.
5. If there are any medical expenses that have not been reimbursed and exceed 7.5% of your annual gross income (AGI).
6. If you are having a baby or adopting one.
7. If the beneficiary makes a withdrawal after the IRA owner’s death.
8. An IRS levy.

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Roth IRAs

What is the penalty for making an early withdrawal from a Roth IRA?

In a Roth IRA, you make a contribution from your after-tax dollars which means that you have already paid tax on your contributions for the year when you make them. Thus, Roth IRA withdrawals are not subject to income tax, otherwise, it would result in double taxation.

Suppose you withdraw a sum equal to the amount you contributed to your Roth account. Herein, the withdrawal will not be deemed as taxable income, no matter what your age. Moreover, the said amount will not be subject to penalty. On the other hand, if you withdraw a sum greater than the amount contributed by you i.e. your earnings, that amount will most likely be considered as taxable income. Further, this amount may attract the 10% early distribution penalty and would be treated as income.

Do note that if you make a contribution and distribute it during the same tax year along with the accrued earnings, the said amount will not incur a penalty. That said, you will need to declare the earnings as investment income.

Are there any exceptions to an early withdrawal penalty from a Roth IRA?

In a Roth IRA qualified distributions are tax and penalty-free. For a distribution to be considered as qualfied, the account owner must have held the account for at least 5 years and satisfies the following conditions:

1. The Roth IRA account owner must be at least 59.5 years of age or above.
2. The Roth IRA account owner is disabled at the time of distribution.
3. The beneficiary of Roth IRA account receives the funds after the owner’s demise.
4. The Roth IRA account owner uses the funds to buy, build or rebuild a home for the first time.

Any withdrawals that do not meet the above-mentioned criteria will attract taxes and a 10% penalty. That said, the taxes and penalties will be applicable to the earnings only and not the contributed sum.

Moreover, you can avoid the early withdrawal penalty on Roth IRA earnings in the following cases:

1. For paying qualified higher education expenses such as tuition, fees, supplies, and books.
2. If you are a qualified reservist i.e. an inactive member of the military reserve; you can make an early withdrawal when called to duty.
3. For paying medical insurance premiums if you have lost your job
4. For paying unreimbursed medical expenses exceeding 10% of your AGI
5. If you pay substantially equal distributions in succession

To summarize

The decision to make a withdrawal from your IRA should be taken after careful consideration irrespective of the tax and penalties. If you make a wrong call, you may be putting any future potential growth and earnings at risk. Make sure you have assessed all possible alternatives and taken care to minimize any potential taxes and penalties before choosing to withdraw from your IRA.

It is advised that you consult with your financial advisor before withdrawing any funds from your retirement account. Use the free advisor match service to connect with 1-3 financial advisors based on your financial requirements. All you need to do is answer a few simple questions about yourself and the match tool will find advisors that match your financial needs.