Early Penalties on the IRA
It is not advisable to take money out of an Individual Retirement Account (IRA) before you are eligible for a distribution. For a traditional IRA, eligibility starts at age 59 1/2. For a Roth IRA, you must meet the age threshold and have owned the Roth IRA for at least five years. Early distributions are assessed tax penalties.
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Early Distribution Penalty
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The Internal Revenue Service assesses a 10 percent penalty tax on early distributions. Traditional IRAs have the entire distribution added to adjusted gross income and are penalized 10 percent. Roth IRAs are funded with after-tax dollars, so all contributions can be taken out tax free but the earnings are subject to income tax and the 10 percent penalty applies to early distributions.
Penalty Exceptions
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The IRS recognizes certain financial scenarios as hardship situations and allows early distribution access to IRA accounts without assessing the 10 percent penalty. IRA assets distributed upon the death of the IRA owner are exempt. Distributions resulting from permanent disability also are exempt. Penalties are waived if you take $10,000 to buy yourself, a child or grandchild a first home. Paying for a college education with IRA funds is exempt, as well.
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Recording Penalties
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The distribution is done after completing a distribution form with the IRA custodian. If you qualify for an exception, note this on the distribution form in the correct section. A 1099-R is sent to you in January of the year following the distribution. Box 7 of the 1099-R should show a code representing the exemption, if there is one. Codes "2", "3" and "4" represent known exceptions, while Code "1" is an early distribution with no exception. Normal distributions have Code "7." The taxable portion listed in Box 2 is added to annual adjusted gross income and a Form 5349 is completed with your tax return to record penalties or exemptions.
Considerations
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Because you can not replace previous years' contributions after distributions are taken, you lose the ability to replenish your IRA after financial stresses slow down. If at all possible, use other savings or taxable investments to preserve retirement assets and preserve tax liabilities. Another thing to consider is whether you have an employer-sponsored plan, such as a 401k, that allows loans. The IRS allows a loan of up to $50,000, or up to 50 percent, of a 401k balance without a credit check. There is no tax liability as long as the loan is repaid within five years. The IRS allows no loan provisions on IRAs.
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