Tax Penalties for Early Distributions from Ira

Individual Retirement Account (IRA) is a type of tax advantaged retirement savings plan. Some Americans use IRAs as their principal vehicle for retirement savings. Others use IRAs to supplement their employers provided retirement plans. 

There are 4 types of IRAs: traditional IRAs and Roth IRAs which are established and funded by individual contributions, and SIMPLE IRAs and SEP IRAs which are employer sponsored IRAs. The Internal Revenue Service (IRS) has established rules governing IRA withdrawals. Early withdrawals from an IRA (withdrawals before age 59 ½) are generally subject to an additional tax penalty. Additionally, the IRS has made special early withdrawal rules that apply to Roth IRAs and SIMPLE IRAs.   

General rule: 10 percent penalty assessed on early withdrawals 

Early withdrawals are withdrawals made by the owner of an IRA before the owner reaches age 59 1/2. While an IRA owner is legally permitted to make withdrawals from an IRA at any time, early withdrawals are generally subject to a tax penalty equal to 10 percent of the early withdrawal. A number of exceptions to the 10 percent penalty exist. Among the more common exceptions are:

* Withdrawals to pay health insurance premiums by an unemployed IRA owner

* Withdrawals of $10,000 or less to purchase a first home

* Withdrawals to pay for qualified educational expenses for the IRA owner, the IRA owner’s children, and the IRA owner’s grandchildren

* Withdrawals to refund current tax year contributions to an IRA as long as the withdrawal occurs before the due date of the IRA owner’s tax return

* Withdrawals due to an IRS tax levy

* Withdrawals that are Qualified Reservist Distributions.

If the IRA owner satisfies the requirements for one of the exceptions, then the IRA owner will not be subject to the 10 percent penalty for that early withdrawal. The general early withdrawal rule applies to withdrawals from all 4 types of IRAs. 

Early distributions from Roth IRAs 

In addition to the general rule imposing a 10 percent tax penalty on withdrawals made before age 59 ½, Roth IRA withdrawals made within the first 5 years after the Roth IRA was set up and funded, are also subject to the 10 percent tax penalty. A withdrawal made from a Roth IRA during the first 5 years after the Roth IRA was set up and funded will trigger the 10 percent penalty even if the account owner is over age 59 ½ when the withdrawal is made. The 5 year rule’s 10 percent penalty may be avoided if 1 of the exceptions listed under the general rule exists. 

Early withdrawals from SIMPLE IRAs 

The general rule on early withdrawals also applies to SIMPLE IRAs. Additionally, withdrawals made from a SIMPLE IRA during the first 2 years of participation are subject to a 25 percent tax penalty unless the withdrawal is a rollover to another SIMPLE IRA. 

Early withdrawals from an IRA usually result in a substantial additional tax penalty. Anyone thinking about taking an early distribution from an IRA should always take the tax implications into account before deciding to take the early distribution.