Inappropriate Withdrawal of Money From an Individual Retirement Account (IRA) Can Result in Significant Fees
A traditional individual retirement account, also known as an IRA, can be an excellent tool for saving for retirement; however, it can also be an excellent tool for tax planning, providing those who qualify with some immediate tax advantages.
You can set aside money in a traditional IRA, where it will continue to grow tax-deferred until it is withdrawn. It also depends on your modified adjusted gross income (MAGI) and whether or not an employer-sponsored plan covers whether you are eligible to take a tax deduction for the annual contributions you make to the account. If you are, then you are eligible to do so.
However, in exchange for these benefits, the Internal Revenue Service imposes a number of stringent rules for withdrawals. If you fail to comply with these rules, you may be subject to tax penalties of up to fifty percent of the original amount.
Key Takeaways
- If a traditional individual retirement account (IRA) is what you have, then the growth of your money is exempt from taxation until the point that it is withdrawn.
- Take withdrawals from your retirement account before you reach the age of 59 and a half. You will be subject to an additional 10 percent early distribution penalty on top of any income taxes that are owed, with a few exceptions.
- Should you fail to take the full amount of your required minimum distributions, you will be subject to a penalty equal to 50 percent of the difference between the amount that should have been distributed and the amount that you actually withdrew.
Withdrawals from a Traditional IRA That Are Subject to Taxes
No matter when you take them out, withdrawals from a traditional IRA are always subject to the same level of taxation as your regular income, with one notable exception: the return of previously made nondeductible contributions. The payment of taxes is merely postponed until the point at which you withdraw money from the account; this is the nature of tax-deferred growth.
When you reach the age of 59.5, you are eligible to begin taking withdrawals from your retirement account and are no longer subject to the early distribution penalty of 10 percent of the amount withdrawn.
The Charged Penalty for Early Distribution
The most problematic aspect of cashing out a traditional IRA is doing so before reaching the age requirement of 59.5. If you haven't reached this age by the time you take your first distribution from an IRA, you'll owe income taxes plus an additional early distribution penalty of 10 percent. This penalty is in addition to the taxes that will be due.
For certain taxpayers, the early distribution penalty can reduce the value of the withdrawal by almost half, effectively halving the original amount.
There are a few exemptions to the early withdrawal penalties that apply to traditional IRAs
Under certain conditions, you are able to withdraw money from your traditional IRA before you reach the age of 59.5, free of any penalties. The following are examples of situations that fall into the category of "exceptions," also known as "exceptional circumstances":
- When you pass away, the beneficiary receives the account value that was left in it.
- You are rendered completely and irreversibly unable to function.
- When you have unreimbursed medical costs that amount to more than 7.5 percent of your adjusted gross income (AGI) or more than 10 percent if you are under age 65, you can take money out of your retirement account early to cover those costs.
- You have been jobless for a period of twelve weeks or more, and you decide to take money out of your IRA so that you, your spouse, or your dependents can pay for health insurance. You have up to sixty days to claim the distribution after you return to work, but you must do so before the deadline.
- You will now begin to receive substantially equal periodic payments in accordance with a predetermined distribution plan. You should be aware, however, that if you do this, you won't be able to get out. After you have started receiving payments, you cannot subsequently change your mind and terminate the agreement.
- Your withdrawal is put toward paying for eligible higher education expenses incurred by you, your spouse, your dependents, or the beneficiary of your account.
- You must use your withdrawal of up to $10,000 for a qualified first-time home purchase within the first 120 days after the time you take it out of your account. This exemption applies to constructing or rebuilding a primary residence for the first time.
- If you are a member of the National Guard or you and a reservist are called to active duty for a period of at least 180 days, they may place some restrictions on your service.
- Within the first sixty days after making a withdrawal from your IRA, you transfer the money into another IRA.
In some of these scenarios, taking an early withdrawal from your individual retirement account (IRA) might not be the most prudent choice financially. You may be able to avoid paying the additional tax of 10%, but you will forfeit any potential future investment growth that you could have made with this retirement plan money.
Minimum Distributions That Are Required
According to the regulations established by the SECURE Act, passed in the latter half of 2019, required minimum distributions (RMDs) must begin by the age of 72 for those younger than age 70.5 before January 1, 2020. Those who reached age 70.5 on or before December 31 in 2019 are obligated to keep making their RMD contributions as required under the previous rules.
You have until April 1 of the year following the year in which you reached the age at which RMDs are required to begin to take your first required minimum distribution (RMD) from your individual retirement account (IRA). This will allow you to maximize the benefits of tax-deferred growth. If you do this, you will have to withdraw money from the account twice during that calendar year, which may result in a significant increase in the amount of taxes you owe during that year.
After the first year that your RMD is calculated, you have until the end of December of each year following that year to calculate and take your RMD.
Your traditional IRA account balance determines your required minimum distribution (RMD) as of the last day of the calendar year before the one in question (December 31). Your age is factored into the equation, and the results are compared to the appropriate IRS table. IRA custodians are legally obligated to perform the aforementioned calculations and provide the results to the Internal Revenue Service (IRS).
The failure to take your full RMD will result in a penalty equal to fifty percent of the difference between the amount that you actually withdrew and the amount that should have been distributed. In addition to the amount that should have been penalized, the taxes that you should have withheld from the amount that you did not withdraw are still owed.
