Early Withdrawal Penalties - Traditional and Roth IRAs in header of articles
Early Withdrawal Penalties - Traditional and Roth IRAs in content page of articles
A big difference exists between withdrawing funds from a traditional IRA and withdrawing funds from a Roth IRA.
The IRS will charge you a 10% early withdrawal penalty if both of these apply:
You withdraw money from your traditional IRA.
You're younger than age 59 1 / 2.
This is true unless you qualify for an exception
Ex: You're age 51 and you withdraw $10,000 from your traditional IRA. Since you don't qualify for an exception:
The IRS will charge you a $1,000 penalty on the withdrawal.
You’ll pay income tax on the entire distribution amount.
If you're in the 25% tax bracket, you'll pay $2,500 in federal income taxes. However, if you made nondeductible contributions, part of the withdrawal would be tax-free as a return of your basis.
Exceptions to the 10% early withdrawal penalty include:
Death -- If the IRA is distributed because the owner dies, there’s no penalty. It doesn't matter how old the IRA owner was at the time of death, or the age of the beneficiary.
Disability -- There’s no penalty if you become permanently disabled. To qualify for the disability exception:
You must be unable to do substantial gainful activity.
Your disability -- either mental or physical -- must be expected to last longer than a year or lead to death.
Medical bills -- You might use money to pay unreimbursed medical expenses that are more than 7.50% of your adjusted gross income (AGI). If you do, you won't pay a penalty.
Ex: Your AGI is $100,000 and includes a withdrawal of $10,000 from your IRA to pay medical bills. So:
7.50% of your AGI is $7,500
$2,500 of the amount you withdrew ($10,000-$7,500) won't incur the 10% early withdrawal penalty
Medical insurance -- If you meet certain conditions, you'll pay no penalty on IRA distributions you used to pay medical insurance for:
To receive the penalty exemption, you must meet all of these conditions:
You lost your job. If you're self-employed and your business is defunct, you might also qualify for this exception.
You must get unemployment pay for at least 12 weeks in a row.
You receive the distributions in the year you received the unemployment compensation or the following year.
You receive the distributions no later than 60 days after you've been re-employed.
Payments over life expectancy -- You’ll pay no penalty if the IRA distribution is part of a series of substantially equal payments over:
Lives of you and your beneficiary
For this exception, you must follow the IRS-approved distribution methods to figure the required payments. These withdrawals must last for at least 5 years and until you’re at least 59 1 / 2 to avoid the penalty.
First-home purchase -- You can withdraw up to $10,000 from an IRA without a penalty if you use it to help pay to buy, build, or rebuild a first home for:
Children or grandchildren
Parents or other ancestor
The lifetime limit is $10,000 . However, you and your spouse can each withdraw $10,000 from your IRAs -- for a total of $20,000 .
You must use the money within 120 days from the date you withdrew it to qualify for the exception. A first-time homebuyer for purposes of this exception is someone who hasn’t owned an interest in a main home for at least 2 years.
Education expenses -- You won’t pay a penalty if you use the money to pay higher-education expenses for:
Qualified expenses for all students include:
Room and board -- Students must be enrolled at least half-time for this expense to qualify.
The expenses must be required for attendance at a:
Other postsecondary educational institution
Qualified reservists -- You don't have to pay the additional 10% penalty tax on your distributions if you meet all of these conditions:
You were ordered or called to active duty after Sept. 11, 2001.
You were ordered or called to active duty for either:
A period of more than 179 days
An indefinite period of time because you were in the reserves in 1 of these forces:
U.S. Army National Guard
U.S. Air National Guard
U.S. Army Reserves
U.S. Navy Reserves
U.S. Marine Reserves
U.S. Air Force Reserves
U.S. Coast Guard Reserves
Reserve corps of the public health service
The distribution is from either:
Amounts from elective deferrals under a 401(k) or 403(b) plan
The distribution was made between these dates:
No earlier than the date of the order or call to active duty
No later than the close of the active-duty period
IRS levy -- If the distribution results from an IRS levy, you won't have to pay the 10% additional tax.
The amount you can withdraw is unlimited. However, the distribution is still subject to tax. It could be taxed at a rate as high as 35% depending upon your tax bracket.
Unlike traditional IRA withdrawals, qualified Roth IRA payments and distributions are tax-free if you meet the requirements.
You must make the withdrawal after the 5-year period beginning with the tax year when you made your first contribution. The account doesn't have to be open 5 full years.
Ex: You opened a Roth IRA on April 15, 2008, for the 2007 tax year. So, 2007 counts as the first year, and you can start making tax-free withdrawals in 2012.
Besides the 5-year period requirement, 1 of these must apply to the payments to be a qualified distribution:
Made after reaching age 59 1 / 2
Made to a beneficiary or to your estate after your death
Made after you became disabled
Meets the penalty exception for first-time homebuyer
When you withdraw your money from a Roth IRA, your contributions and earnings are considered to come out in this order:
Conversion contributions, on a first-in, first-out basis
Earnings on contributions
You've already paid tax on your Roth IRA contributions. So, you can withdraw your regular contributions at any time and at any age with no penalty or tax. After you withdraw an amount equal to all of your regular contributions, the earnings will be taxable. This applies if the distribution isn't a qualified distribution.
Ex: You contribute $4,000 to a Roth IRA each year for 4 years, for a total of $16,000. After 4 years, the account is valued at $20,000. You can withdraw up to $16,000 without paying tax or a penalty.
No matter how many Roth IRA accounts you have, all your Roth IRAs are treated as 1 for withdrawal purposes. Ex: You have 2 accounts -- 1 with $18,000 and another with $2,000. So, you can do either of these and pay no tax:
Withdraw up to $16,000 from just 1 account
Withdraw $2,000 from 1 account and $14,000 from the other account
Converted Amounts and Early Withdrawal Penalty
If you convert a traditional IRA to a Roth IRA, both of these apply:
The money must stay in the Roth IRA account for 5 years beginning with the year you made the conversion.
Your distributions will be tax-free qualified distributions.
Ex: You convert a traditional IRA to a Roth IRA in 2012. So, you can start making tax-free and penalty-free withdrawals in 2016. You can make the withdrawals up to the amount of your conversion contribution, regardless of your age.
You might withdraw contributions before the 5-year period. If so, you might have to pay the 10% early withdrawal penalty on the entire distribution. You usually pay the 10% early withdrawal penalty on the amount you converted. A separate 5-year period applies to each conversion.
If you're at least age 59 1 / 2 when you make the withdrawal, you won't pay the 10% early withdrawal penalty. This applies no matter how long the money is in the account. You also won't pay a penalty if you:
Use the distribution for a first-time home purchase -- up to a $10,000 lifetime limit
Qualify for other exceptions that apply to traditional IRAs
Distribution Ordering Rules for Roth IRAs
If the money you withdraw from a Roth IRA isn't a qualified distribution, part of it might be taxable. By law, your money comes out of a Roth IRA in this order:
Regular contributions, which are always tax- and penalty-free
Conversion contributions, which come out on a first-in, first-out basis. So conversions from the earliest year come out first.
Earnings on contributions
Roth IRA Earnings
Your earnings are tax-free if both of these are true:
You've had the Roth IRA for at least 5 years.
You're 59 and 1 / 2 or older when you withdraw the money.
The earnings you withdraw are tax-free at any age if both of these apply:
You've had the Roth IRA for at least 5 years.
You qualify for 1 of these exceptions:
You used the money for a first-time home purchase -- up to the $10,000 lifetime limit.
You became disabled.
Your heirs received the money distributed after your death.
If you die before meeting the 5-year test, the IRS taxes your beneficiaries on earnings until you meet the 5-year test.
No matter your age, your earnings are taxable if you don't meet the 5-year test -- even if your earnings are penalty-free.
Ex: If you use your Roth IRA withdrawal to pay college expenses, you won’t pay a 10% penalty. However, the money will be taxed unless you pass the 5-year test and you're over 59 1 / 2.
Also, there is only 1 5-year test for annual contributions.
Ex: If you open your first Roth IRA in 2008, you meet your 5-year holding period in 2013. You might also a second Roth IRA someplace else with a 2009 contribution. If so, you also meet your 5-year holding period for this account beginning in 2013.
However, each traditional IRA you convert to a Roth IRA has its own 5-year holding period.
The IRS requires your IRA custodian or trustee to send you Form 5498 showing your:
Annual IRA contributions
Roth IRA conversions
You should receive the form by the end of May. Keep these records even though you don’t report your Roth contributions on your return.
When you withdraw money from your Roth IRA, report it on Form 8606. This form keeps track of your basis in regular Roth contributions and conversions so you can see if you've withdrawn earnings. If you've held your Roth IRA for at least 5 years and you're older than 59 1 / 2, all withdrawals are tax-free.
Traditional IRA Distributions
If you wait until you're over 59 1 / 2, you won’t pay the 10% early withdrawal penalty. However, if you deduct your traditional IRA contributions, the money you withdraw is taxable. If you made nondeductible contributions, part of your withdrawal will be tax-free.
Required Minimum Distributions
You must begin withdrawing money from your traditional IRA by April 1 following the year you reach age 70 1 / 2. The IRS will assess a penalty equal to 50% of the amount you should have withdrawn if the minimum required amount isn't withdrawn.
If your 70th birthday is between January and June, you'll turn age 70 1 / 2 before the end of that year. At that time, you must begin taking your required minimum distribution from your IRA by April 1 of the following year. However, you might want to take your first distribution in the year you turned age 70 1 / 2. You'd do this to avoid having to take 2 distributions in the next calendar year.
If your 70th birthday is after June 30, both of these apply:
Your first required minimum distribution will be for the next year.
You could wait until April 1 of the following year to take it the distribution.
Minimum withdrawals are based on life expectancy. After you find out what your minimum required distribution is, you can take the full amount from just 1 account or from several accounts.
Ex: If you're required to withdraw $10,000 this year and you have 2 accounts, you can:
Withdraw the entire amount from 1 account
Split the distribution between the 2 accounts
If you fail to withdraw the minimum required amount, you'll be subject to a 50% penalty. However, the IRS might waive the penalty if you have reasonable cause for the failure, like poor health, for not withdrawing the minimum amount.
Getting Your Money Early
You can receive distributions from your traditional IRA before age 59 1 / 2 without paying the 10% early withdrawal penalty. These conditions must apply:
The distributions must be part of a series of substantially equal periodic payments over your life -- or over the joint lives of you and your beneficiary.
You must use an IRS-approved distribution method and you must take at least 1 distribution annually.
You must continue making these periodic withdrawals for at least 5 years and until you're at least 59 1 / 2.
If by age 59 1 / 2 you haven't been receiving payment for at least 5 years, you might have to pay the 10% early withdrawal penalty.
Also, you might still have to pay a penalty if you change your method of distribution after reaching age 59 1 / 2. This might apply even if you haven't take distributions for 5 years. In that case, the tax applies only to payments distributed before you reach age 59 1 / 2.
This distribution method saves you the 10% early withdrawal penalty. However, you'll still have to pay taxes on any amount not considered a return of your nondeductible contributions.
Roth IRA Distributions
If you've held your Roth IRA for at least 5 years and you're older than 59 1 / 2, money you withdraw will be tax-free. If you open a Roth IRA account after you turn 59 1 / 2, you still must wait at least 5 years before you can take tax-free withdrawals of your earnings. However, you can take tax-free withdrawals of your contributions at any time.
There’s no required minimum distribution for a Roth IRA prior to the account owner’s death. So, you're not required to withdraw money during your lifetime. This is an advantage over a traditional IRA.
Death and the Traditional IRA
If a person dies while there's still money in their traditional IRA account, the beneficiaries:
Won’t pay the 10% early withdrawal penalty -- regardless of the deceased’s age or the beneficiaries’ ages
Will pay taxes on distributions the deceased took if the deceased would have paid taxes on the distributions -- even though the funds are inherited
If the deceased had basis in the IRA, the beneficiaries inherit this basis. They must use Form 8606 to figure the taxable portion of distributions from the inherited account.
If you inherit an IRA from your spouse, you can treat the IRA as your own. Then, you can defer taking the minimum required distribution until you reach age 70 1 / 2. If you're not a spouse, you must determine your required minimum distributions from the account. To do this, you must use the IRS life expectancy table for beneficiaries.
Ex: Collin’s father died in 2008. Collin is the designated beneficiary of his father's traditional IRA. Collin is 53 years old in 2009. According to the IRS tables, his life expectancy in 2009 is 31.4 years. If the IRA was worth $100,000 at the end of 2008, his required minimum distribution for 2009 is $3,185 ($100,000 / 31.4).
If the IRA’s value at the end of 2009 is again $100,000, his required minimum distribution for 2012 would be $3,289 ($100,000 / 30.4). Instead of taking yearly distributions, Collin can take a distribution by the end of the fifth year after the year his father died. He can do this for the entire account.
Death and the Roth IRA
Roth IRAs have different guidelines. If you inherit a Roth IRA, the money is tax-free after the IRA meets the 5-year period.
If you inherit the Roth from your spouse, you can treat it as your own. So you won’t need to make required withdrawals during your lifetime.
However, if you're not the deceased’s spouse, you must either:
Withdraw everything from the Roth IRA within 5 years of the owner's death
Begin withdrawals by Dec. 31 of the year after the owner's death. The amount you withdraw is based on your (the beneficiary's) life expectancy.