Most financial experts would agree that it is rarely, if ever, a good idea to withdraw funds early from retirement accounts. This is because of the high cost of penalties that can hit an account holder for an early withdraw.

With a few exceptions, early distributions from IRAs (that is, those made before age 59½) generally incur a tax penalty equal to 10% of the sum withdrawn, plus you may owe income tax on it, as well. Although the IRS imposes the penalty to dissuade IRA participants from using their savings before retirement, this penalty is only applied to the withdrawal of taxable funds.

If you withdraw funds that are not subject to income tax, there is no penalty for distributions taken at any time. So, the key factor in determining the amount of your penalty is the type of IRA you own.

Calculating Penalties on Traditional IRA Withdrawals

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. Any money you defer from your paycheck is subtracted from your taxable income for that pay period, effectively reducing the amount of income tax you pay throughout the year.

However, the IRS eventually collects taxes on all income, so income tax is assessed on your traditional IRA funds upon withdrawal. In general, this means that the entirety of your traditional IRA account balance is comprised of taxable income.

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 IRAs and Penalties for Early Withdrawal

Contributions to Roth IRAs are made with after-tax dollars; you pay income tax on all your contributions in the year when you earned them. As a result, withdrawals of Roth contributions are not subject to income tax, as this would be double taxation.

If you take out only 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.

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.

You must meet two sets of criteria to withdraw these funds without incurring penalty costs. First, you must have held your Roth IRA for five years, and you must be age 59 1/2, or using the funds, up to $10,000, for your first home. You can also withdraw your Roth contributions for higher education costs, but not your earnings, without paying penalties.

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.

The Bottom Line

When you remove money early from traditional IRA accounts, you can expect to pay a 10% penalty plus taxes on the income. If you have a Roth IRA and you meet all the requirements, you can take out your contributions without paying taxes and penalties, but you lose out on the earning potential of those contributions. It is 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.