I need money. How bad is it to withdraw money from my IRA?

All the free government money has been spent and inflation is raging. You are now facing a vicious lack of liquidity. What to do?

One possible solution is to make an early withdrawal from your IRA. By early withdrawal, I mean one that occurs before the age of 59 and a half. Needless to say, there are federal income tax implications, including the possibility of being trapped by the dreaded 10% early withdrawal tax penalty. Here’s what you need to know to make an informed decision.

Early withdrawals from an IRA are generally taxable, but a tax penalty can often be avoided

In almost all cases, all or part of any withdrawal from a traditional IRA will count as taxable gross income. The taxable percentage depends on whether or not you have made non-deductible contributions to the account.

If so, each withdrawal consists of a proportionate amount of your total non-deductible contributions, and that portion is tax-free.

The proportionate portion of each withdrawal made up of deductible contributions and accumulated earnings is taxable. If you have never made non-deductible contributions, 100% of any withdrawal is taxable.

Although it is impossible to avoid triggering taxable income by withdrawing before age 59.5, you may be able to avoid the 10% penalty tax on early withdrawals by taking advantage of the exceptions explained below. . Please read on.

Penalty Tax Exceptions for Early Withdrawals from Traditional IRAs

The following exceptions to the 10% federal tax penalty are available for early withdrawals (before age 59½) from traditional IRAs, which for this purpose include Simplified Employee Retirement Accounts (SEP-IRAs) and SIMPLE-IRA accounts.

1. Substantially Equal Periodic Payments (PPSE)

These are annual annuity-like withdrawals that must be withdrawn for at least five years or until you reach age 59½, depending on later. The rules for SEPP are complicated. You may want to consult your tax advisor to avoid the pitfalls.

2. Withdrawals for medical expenses

If you have eligible medical expenses greater than 7.5% of adjusted gross income (AGI), early IRA withdrawals up to the amount of the excess are exempt from the 10% penalty tax. However, the medical expenses must be paid in the same year that you take the early withdrawal.

3. Withdrawals for qualified higher education expenses

Advance IRA withdrawals are penalty-free to the extent of qualified higher education expenses paid in the same year. Eligible expenses must be for the education of: (1) the Account Holder or the Account Holder’s Spouse or (2) a child, son-in-law or adopted child of the Account Holder or the spouse of the account holder.

4. Withdrawals to pay health insurance premiums during unemployment

This exception is available to an IRA owner who received unemployment benefits for 12 consecutive weeks under any federal or state unemployment compensation law during the year in question or the previous year. If this condition is met, the owner’s early withdrawals from the IRA in the year in question are penalty-free up to the amount paid in that year for health insurance premiums to cover the owner of the account, spouse and dependents. However, early withdrawals after the account holder has returned to employment for at least 60 days are not eligible for this exception.

5. Withdrawals for births or adoptions

Treatment without penalty for qualified distribution of birth or adoption (withdrawal). This means a distribution made within the one-year period beginning on the date of birth of an eligible child of the Account Holder or the date the legal adoption of an eligible adoptee of the Account Holder is finalized . A qualifying adoptee is any person (other than a child of the Account Holder’s Spouse) who has not reached the age of 18 or who is physically or mentally incapable of supporting themselves. The maximum qualified birth or adoption distribution without penalty for any eligible birth or adoption is $5,000, and that limit is apparently enforced individually. So when both members of a married couple have qualifying retirement accounts, each spouse can apparently receive a qualified birth or adoption distribution without a $5,000 penalty.

6. Withdrawals for first-time home purchases ($10,000 lifetime limit)

This exception allows penalty-free IRA withdrawals to the extent of money spent by the account holder within 120 days to pay qualified acquisition costs of a principal residence. However, there is a lifetime limit of $10,000 on this exception. The principal residence may be acquired by: (1) the account holder or their spouse; (2) the Account Holder’s child, grandchild or grandparent; or (3) the spouse’s child, grandchild or grandparent. The purchaser of the principal residence (and the spouse if the purchaser is married) must not have held a current interest in a principal residence during the two-year period ending on the date of acquisition. Eligible acquisition costs are defined as the costs of acquiring, building or rebuilding a principal residence, including closing costs.

7. Withdrawals of military reservists called up for active duty

This exception applies to certain IRA advance withdrawals made by members of the military reserve who are called up for active duty for at least 180 days or indefinitely.

8. Withdrawals after disability

This exception applies to amounts paid to an IRA holder who is found to be physically or mentally disabled to the extent that he or she cannot engage in his or her usual gainful activity or a comparable gainful activity. In addition, the disability is expected to: (1) result in death or (2) be of long or indefinite duration. However, it is not necessary to expect the disability to be permanent to satisfy the previous requirement.

9. Withdrawals to Satisfy IRS Levies

This exception applies to IRA advance withdrawals made to pay IRS levies on the account. However, this exception is not available when the IRS levies against the owner of the IRA (as opposed to the IRA itself), and the owner then withdraws the funds from the IRA to pay the tax.

10. Withdrawals after death

Amounts withdrawn from an IRA after the account holder’s death are still exempt from the 10% penalty tax. However, this exception is not available for funds transferred into a surviving spouse’s IRA or if the surviving spouse chooses to treat the inherited IRA as their own account. If the surviving spouse needs some of the inherited funds, they should be left in the inherited IRA (i.e. the one still considered to have been set up for the deceased spouse). Then, the surviving spouse can withdraw the necessary funds from the inherited IRA without any 10% tax penalty, thanks to this exception.

What about an early withdrawal from the Roth IRA?

The immediate tax results will likely be better for an early Roth IRA withdrawal (before age 59½) than for an early traditional IRA withdrawal. This is because you will owe no federal income tax on early withdrawals that consist of annual Roth IRA contributions or contributions from converting a traditional IRA to Roth status. These federal income tax-free dollars are deemed to come out of the account first.

Under a strange but true rule, you may owe a 10% early withdrawal tax penalty, but no federal income tax, on withdrawals that consist of conversion contribution dollars. But you will only be liable for the tax penalty if the withdrawal takes place within five years of the conversion contribution. And all of the exceptions to the 10% tax penalty explained in the context of traditional IRA early withdrawals also apply here.

Once you have withdrawn all Annual Contribution and Conversion Contribution dollars, what remains in your Roth account is Account Earnings. Withdrawals of income from the account are fully taxable unless you have had at least one Roth account open for more than five years and are 59.5 years or older.

For more details on how Roth withdrawals are taxed, see this previous Tax Guy column.

Bottom Line: Early IRA Withdrawals Should Be a Last Resort

As explained, most or all of an early traditional IRA withdrawal will likely be taxable. And the withdrawal could push you into a higher federal marginal tax bracket. You will likely also owe the 10% early withdrawal penalty tax, and possibly state income tax as well. And, the only way to replace the money withdrawn from your traditional IRA is to make future contributions to fill the reservoir. It could take many years. In the meantime, you have less money to invest tax-free.

The immediate tax consequences of early withdrawals from the Roth IRA are generally less severe. But, again, it may take years of future contributions to get back to square one, and the end result will be less tax-free federal income tax money available when you reach retirement age. .

For all of these reasons, taking an early IRA withdrawal to resolve a cash flow crisis should be a last resort. Unfortunately, sometimes this is the only option.

About Clara Barnard

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