IRA Early Distribution Tax
IRAs are Individual Retirement Accounts. These accounts are tax shelters that defer the payment of tax on retirement savings until you retire and start making withdrawals. If you decide to take early withdrawals, there is an early-distribution penalty, which takes the form of a tax on the amount you withdraw.
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Types
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Two types of IRAs are subject to early-withdraw penalties. A traditional IRA accepts tax-deductible contributions. A Roth IRA only accepts after-tax contributions. While both IRAs are subject to these penalties, the penalty applies differently depending on which type of IRA you own, though the amount of the penalty remains the same. For both IRAs, the penalties are paid as a 10 percent excise tax.
Significance
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With a traditional IRA, the penalty is paid on the entire amount of your withdrawal. This is because no contributions have been taxed yet. For Roth IRAs, the penalty is only assessed on your investment gain. However, IRS rules allow you to remove the principal prior to removing your investment gain from your Roth IRA, so you don't automatically pay a penalty on all withdrawals.
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Prevention
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To prevent a penalty, you must either avoid making withdrawals from your traditional IRA, limit your withdrawals to principal amounts on a Roth IRA, or make withdrawals using IRS rule 72(t). IRS rule 72(t) allows you to make early distributions that are equal and substantial (based on your life expectancy using IRS mortality tables in the appendix of publication 590) and that last for at least five years or until age 59 1/2, whichever comes later.
Consideration
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Before making any withdrawals from your IRA, consider what your financial goals are. It might be appropriate to make early withdrawals from your IRA, but this process may be too complicated for you to undertake by yourself. If you do not perform the 72(t) calculations properly, you will incur a penalty. Consider working with a financial adviser who is knowledgeable about this type of early-withdrawal strategy.
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