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Individual Retirement Accounts (IRA), which offer greater flexibility in terms of investment, are preferred by Americans looking for retirement planning tools apart from the employee sponsored options such as pension funds and 401(k)s. These accounts are great for retirement planning but it is generally not advisable to withdraw money before the account holder reaches the age of 591/2. Distributions before the age 591/2 are called early distributions. IRS penalizes early distributions by imposing a 10 percent additional tax on the withdrawal amount. If you're wondering, how are taxes are collected on early IRA distributions, it depends on whether they are qualified distributions or not.
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How are Taxes Collected in an Early Distribution?For a traditional IRA account, there can be two types of contributions to the account, tax-deferred contributions and after-tax contributions. When a person takes a distribution from his traditional IRA, he has to pay income tax for the tax-deferred contributions as well as earnings from his contributions. At the same time, contributions which did not get a tax-exemption can be withdrawn without paying tax. If income tax is applicable for the distribution, it is calculated by adding the distributed amount to his Gross Adjusted Income. For example if a person withdrew $5,000 from his IRA, that $5,000 will be added to his Gross Adjusted Income for calculating income tax.
- slide 3 of 7Early distributions are those distributions which are taken before the person reaches the age of 591/2. Except in cases where the distributions are qualified distributions(discussed later), the account holder will have to pay an additional 10 percent as tax. In the above example, if the $5,000 was withdrawn before the account holder was 591/2, and the distribution did not qualify as a qualified distribution, he is bound by law to pay 10 percent of $5,000 ($500), as a penalty. This penalty is in addition to any income tax that he may incur when the withdrawn amount is added to his adjusted gross income.
- slide 4 of 7The rules for calculating taxes varies slightly between the IRAs. In the case of a Roth IRA, if five tax years have elapsed between the contribution and the distribution, the distributed amount is not included in the gross adjusted income of the individual, while in the case of a SIMPLE IRA, the penalty for an early distribution can be as high as 25 percent of the distributed amount.
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Qualified Distributions for IRAs
The 10 percent penalty applicable for early distributions from an IRA can be waived when these distributions fall into an allowed list of exceptions. Allowed distributions (qualified distributions) from an IRA include withdrawal for a first-time home purchase, higher education expenses, medical expenses that were not reimbursed, medical insurance for the unemployed, and distributions due to a disability. In the case of inherited IRAs, where the account holder expires before he reaches 591/2, distributions to the beneficiary or to an estate are not counted as early withdrawals and the 10 percent additional tax is not applicable. Another scenario where the penalty is not applicable is when the account holder decides to withdraw equal amounts from his IRA over his lifetime.
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Early distributions from IRAs should be avoided when possible. Because IRS penalizes a person heavily for taking a distribution from his IRA, it is in his best interest to be familiar with how are taxes collected on early IRA distributions to avoid those tax penalties.
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Resources1. Publication 590 on IRAs by IRS, http://www.irs.gov/pub/irs-pdf/p590.pdf2. IRS Website, http://www.irs.gov/taxtopics/tc558.htmlImage Credit: http://www.flickr.com/photos/alancleaver/4105756012/