What Happens When You Withdraw Money From a Traditional IRA?
Individual retirement accounts, or IRAs, are tax-sheltered investments that encourage working people to save for retirement. As such, people who invest in IRAs are penalized for taking withdrawals, also called distributions, before they reach age 59 1/2--unless they use the money for a qualifying purpose. People who take unqualified distributions owe the IRS a hefty penalty.
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Traditional IRAs allow savers to deduct the total amount of their annual contribution from their income taxes. Once the money is deposited in the IRA, it is allowed to accumulate tax-free earnings until the account holder begins taking distributions. Qualified distributions are subject to federal income tax rates rather than capital gains taxes.
Distributions
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IRAs were designed to provide retirement income. Thus, those with IRAs can start taking distributions when they turn 59 1/2. They will pay income taxes on those distributions, but they won't be charged early-withdrawal penalties. Traditional IRAs also require people to begin collecting a minimum distribution when they turn 70 1/2--traditional accounts do not allow the investment to grow, tax-free, indefinitely.
Those who withdrawal money before they 59 1/2 owe the IRS a 10 percent penalty, plus any applicable taxes, unless they qualify for a penalty exception.
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Penalty Exceptions
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The IRS does allow people to withdrawal money early from a traditional IRA without penalty in specific situations, though the withdrawals are still subject to income taxes. First-time home buyers can take up to $10,000 to make a down payment within 120 days of the withdrawal. Traditional IRA funds also may be withdrawn early to pay for education expenses in the account holder's immediate family. If an account holder dies before turning 59 1/2, the IRA's beneficiary may withdrawal money without penalty.
Medical Expenses
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Traditional IRA holders can take early distributions to cover medical expenses. If the holder has unpaid medical bills that exceed 7.5 percent of his income, he can withdraw money to pay them. Traditional IRA funds may also be withdrawn, by people who have been unemployed for at least 12 weeks, to pay health insurance premiums for dependents and those in the immediate family.
Disability
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The IRS allows penalty-free withdrawals to disabled account holders. According to the IRS's code, disability is defined as a mental or physical condition, either fatal or expected to continue indefinitely, that prevents a person from engaging in gainful employment.
Required Minimum Distributions
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The IRS mandates that those with traditional IRAs begin taking required minimum distributions, or RMDs, by April 1 in the year they turn 70 1/2. They must continue taking an annual RMD by Dec. 31 each subsequent year until their death.
Traditional IRA holders who do not take RMDs are subject to a whopping 50 percent tax penalty. The RMD is calculated based on the IRA's worth and the life expectancy of the account holder.
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References
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