Most financial experts would agree that it is rarely, if ever, a good idea to take an early withdrawal from a traditional IRA or Roth IRA. This is due in part to the high cost of penalties that can hit an account holder for an early withdrawal (not to mention losing out on years of potential earnings).
Early distributions from IRAs (that is, those made before age 59½) generally incur a 10% tax penalty, plus you may owe income tax on it, as well. The Internal Revenue Service (IRS) imposes the penalty to dissuade IRA holders from using their savings before retirement. But the penalty only applies if you withdraw taxable funds.
If you withdraw funds that are not subject to income tax, there is no penalty for distributions taken at any time. Whether funds are taxable comes down to the type of IRA you own.
- You can withdraw Roth IRA contributions at any time with no tax or penalty.
- If you withdraw earnings from a Roth IRA, you may owe income tax and a 10% penalty.
- If you take an early withdrawal from a traditional IRA—whether it's your contributions or earnings—it may trigger income taxes and a 10% penalty.
- Some early withdrawals are tax-free and penalty-free.
Traditional IRA Withdrawal Penalties
To calculate the penalty on an early withdrawal, simply multiply the taxable distribution amount by 10%. An early distribution of $10,000, for example, would incur a $1,000 tax penalty, and it would be treated (and taxed) as additional income.
Early distributions from traditional IRAs are the most likely to incur heavy penalties. Contributions to this type of account are made with pretax dollars. Your contributions are subtracted from your taxable income for the year, effectively reducing the amount of income tax you'll owe.
You get an upfront tax break when you contribute to a traditional IRA, but you'll pay taxes on your withdrawals in retirement.
However, the IRS eventually collects taxes on all income, so income tax is assessed on your traditional IRA funds when you withdraw them. In general, this means that the entirety of your traditional IRA account balance is comprised of taxable income.
Therefore, if you withdraw funds before age 59½, the 10% tax penalty likely applies to the full amount of the distribution. After accounting for the impact of income taxes and penalties, an early distribution from a traditional IRA is rarely an efficient use of funds.
Roth IRA Withdrawal Penalties
Contributions to Roth IRAs are made with after-tax dollars. That means you pay income tax on your contributions the year you make them. As a result, withdrawals of Roth contributions are not subject to income tax, as this would be double taxation.
There's no upfront tax benefit for Roth IRA contributions, but earnings grow tax-free and withdrawals in retirement are tax-free, as well.
If you take out an amount equivalent to the sum you put into your Roth, the distribution is not considered taxable income, regardless of your age, nor is it subject to penalty.
You can always withdraw Roth IRA contributions tax-free and penalty-free.
You may be able to avoid the tax and penalty on early withdrawals in certain situations.
If you don't have any other options, it can be comforting to know your IRA is there for you.
Most early withdrawals trigger tax and a 10% penalty.
You can't "pay back" the money to your IRA once you take it out.
If you take money out of your IRA, you'll miss out on years (or decades) of growth.
Now, if you withdraw an amount above that—if you start dipping into the account's earnings—that amount is generally considered taxable income. It may also be subject to the 10% early-distribution penalty, and the money would be treated as income.
How Qualified Distributions Work
Qualified distributions from a Roth IRA are tax-free and penalty-free. The IRS considers a distribution to be qualified if it's been at least five years since you first contributed to a Roth IRA and the withdrawal is as follows:
- Made when you're age 59½ or older
- Taken because you have a permanent disability
- Made by your beneficiary or estate after you pass away
- Used to buy, build, or rebuild a home that meets the first-time homebuyer exception.
Non-qualified distributions are any withdrawals that don't meet these guidelines. For these withdrawals, you'll owe taxes at your ordinary income tax rate (remember, it just applies to earnings) and a 10% penalty.
Still, certain exceptions apply. You can get out of the penalty (but not the tax) if you take the distribution for the following:
- A series of substantially equal distributions
- Unreimbursed medical expenses that exceed 10% of your adjusted gross income (AGI)
- Medical insurance premiums after losing your job
- An IRS levy
- Qualified reservist distributions
- Qualified education expenses
Tax Implications for Roth IRAs
There is yet another loophole for earnings on Roth contributions, however. If you contribute and then withdraw within the same tax year, then the contribution is treated as if it were never made.
For example, if you contribute $5,000 in the current year and those funds generate $500 in earnings, you can withdraw the full $5,500 penalty-free, as long as the distribution is taken prior to your tax filing due date. You would have to report those earnings as investment income, however.
Investors have the option of converting their traditional IRA to a Roth IRA. There are many benefits to converting, such as no forced requirement of withdrawals by a certain age. The benefit of converting also depends on your tax bracket. If you do convert, you will have to pay taxes on the amount that you convert. So if you expect to be in a lower tax bracket in the future when you withdraw the funds, then it might not make sense to convert now.
If you are under age 59½, and you utilize your traditional IRA funds to pay for the taxes when you do convert, you will incur a 10% penalty. Notably, a conversion itself is not a withdrawal, so there are no withdrawal penalties associated with a conversion.
The Bottom Line
If you have a Roth IRA, you can take out your contributions at any time without paying taxes and penalties. Otherwise, if you remove money early from either a traditional or Roth IRA, you can expect to pay a 10% penalty plus taxes on the income (unless you qualify for an exception).
Of course, the decision to take an early withdrawal should never be taken lightly. You could miss out on years of potential growth and earnings, which could have a detrimental effect on your nest egg.
It's rarely advisable to raid retirement accounts. But many of the best brokers for IRAs have further information on how to avoid these penalties if you must access your funds before retirement.