If you withdraw money from an individual retirement account before age 59 ½, you typically incur a 10 percent early withdrawal penalty. The 10 percent tax applies in addition to the regular income tax due on withdrawals from IRAs.
For example, if a worker who is in the 25 percent tax bracket withdraws $5,000 from an IRA at age 40, he will owe $1,250 in regular income tax and $500 for the early withdrawal penalty. He will only get to keep $3,250.
However, more people are now successfully avoiding the early withdrawal penalty than in previous years. The number of people paying the penalty for early withdrawals from their retirement account has declined significantly over the past five years from 1.2 million in 2009 to 690,780 in 2013. And the amount paid in penalties has been cut in half from $456 million in 2012 to $221 million in 2013, according to recently released 2013 IRS tax return data.
People whose adjusted gross income is between $50,000 and $75,000 and those earning from $100,000 to $200,000 were the most likely to take early withdrawals from their retirement accounts, with over 100,000 people in each income bracket taking early distributions. People making in the low six figures also paid the most in fees, totaling $34 million, followed by people earning between $40,000 and $50,000, who paid just under $31 million in penalties. Married couples take more early withdrawals (369,849) than single people (275,213), but single people paid more in penalties, totaling $128 million, compared to $61 million among married couples filing jointly.
The dollar amount of the penalty is based on the amount withdrawn from the account. A $10,000 withdrawal will result in a penalty of $1,000, while a $50,000 withdrawal triggers a $5,000 early withdrawal tax.
The simplest way to avoid the IRA early withdrawal penalty is to wait until age 59 ½ to begin withdrawing money from your IRA. You can also avoid the tax if you use your early IRA distribution for specific purposes. There is no penalty if the withdrawal is used to pay for significant medical costs, health insurance after a layoff or to cope with a disability. If your health care costs exceed 10 percent of your adjusted gross income and aren’t covered by insurance, you can withdraw money from your IRA for these costs without penalty. You’re also eligible for a penalty-free withdrawal if you need to purchase health insurance for yourself and your spouse and dependents following job loss and at least 12 consecutive weeks of collecting unemployment compensation. The 10 percent penalty doesn’t apply if you have a severe physical or mental disability that prevents you from working.
However, you don’t necessarily need a personal crisis to avoid a penalty on IRA distributions before age 59 ½. Buying a home and paying for college are also qualifying expenses. Withdrawals that are used to pay for college costs aren’t subject to a penalty, but they could reduce your eligibility for financial aid. And you can withdraw up to $10,000 ($20,000 for couples) from an IRA for a first home purchase without penalty.
Another option to get your money out of an IRA early is to set up a series of annuity payments. You need to use a distribution method based on your life expectancy that is approved by the IRS and take one or more withdrawals per year to avoid the penalty.
There’s less of a penalty if you take early distributions from a Roth IRA. Withdrawals of your contributions from a Roth IRA that is at least five years old won’t trigger the early withdrawal penalty, although early distributions of the investment earnings in the account could be subject to the penalty. You can also roll over your traditional IRA balance to a Roth IRA without paying the 10 percent tax on early withdrawals, although you will still have to pay income tax on the amount converted.
Of course, the early withdrawal penalty exists to encourage savers to use the money to pay for retirement. Even if you manage to avoid the early withdrawal penalty, you still miss out on years of tax-deferred investment growth when you take money out of an IRA early.
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Fewer People Pay IRA Early Withdrawal Penalty originally appeared on usnews.com
