How to Calculate Capital Gains on an IRA Early Withdrawal

If you withdraw money early from an individual retirement account, the one thing you do not need to worry about is the capital gains tax. You do need to know what kind of IRA you have, how much you have contributed, how much your contributions have gained and if you qualify for a penalty-free withdrawal. All early withdrawals owe a ​10 percent​ penalty unless withdrawn under specific circumstances.

What you owe the Internal Revenue Service (IRS) for the withdrawal depends on a few key factors, especially the type of IRA. The IRS will treat all capital gains earned within an IRA as ordinary income once it is distributed to be taxed at your marginal rate.

How Are IRAs Taxed vs. Capital Gains?

Capital gains are taxed at a different, typically lower, rate than income. Capital gains are the result of earnings resulting from the sale of assets, such as stocks or real estate. While IRAs often contain assets that would normally be assessed capital gains taxes, the fact that they are in a retirement account changes things.

In a traditional IRA, withdrawals are taxed as income, regardless of the investment type. A Roth IRA on the other hand is not taxed on withdrawals, because contributions are taxed before they go into the account.

The IRS has strict guidelines regarding IRA withdrawals that may include a penalty in addition to taxes be paid. A distribution may be qualified for a penalty exception based on the reason for withdrawal. If you are older than ​59-1/2​, the distribution is not an early withdrawal and cannot be penalized. If you are withdrawing money to pay for your first house, higher education of yourself or an immediate relative, costs of a disability or medical bills over 10 percent of your income, you will not be penalized.

Why Does the Type of IRA Matter?

Essentially, IRAs are either tax-deferred or tax-exempt. Traditional IRAs are tax-deferred, and Roth IRAs are tax-exempt. Determine if you have a traditional IRA or a Roth IRA. If you deduct your contributions from your taxable income, you have a traditional IRA. If you do not, you have a Roth IRA. The company that manages your IRA can provide this information if you are unsure.

Traditional IRAs are tax-deferred, which means that the amount you contribute is deducted from your income in the year it goes into the IRA. Withdrawals from a traditional IRA are taxed when you take distributions from the account. If you are not ​59 1/2​ then a penalty may apply in addition to taxes.

Roth IRAs are not tax-deferred because the taxes have been paid prior to depositing into the account. You may withdraw funds from your direct contributions, or basis, from a Roth IRA without penalty or tax at any time. If you withdraw an amount less than the total value of your basis, you do not have to pay any tax. If you withdraw from the earnings in your Roth IRA, then both taxes and penalties may apply if you are not yet ​59 1/2 years of age​.

What's the Difference Between Taxes and Penalties?

Taxes on an IRA are based on the amount you pay according to your tax bracket at the end of the year, and the rate of taxation is based on your income. Penalties are additional money to be paid along with taxes for non-qualified distributions. The penalty for an IRA is ​10 percent​, which is assessed on the entire amount subject to penalty before the taxes are taken out. Taxes owed will also be based on the total amount, there is no discount for penalties. States may also assess a penalty in addition to tax.

Carefully determine the amount you need to withdraw and your income bracket. If you have a traditional IRA, the total amount is considered taxable income, including all capital gains (which are regarded as income upon withdrawal). You must pay income tax at your current income tax rate on the withdrawal. Take into account the cost of taxes and any penalty and whether you might be eligible for a qualified distribution.

The CARES Act has created a few changes to the IRS rules on IRA taxes and penalties. Distributions taken in ​2020​ out of hardship as a direct result of the Coronavirus are exempted from the ​10 percent​ early withdrawal penalty, even you have not reached the ​age of 59 1/2​. These distributions may be repaid over three years at your regular tax rate. The combined limit for Coronavirus distributions is ​$100,000​.

How to Determine IRA Penalty and Taxes

Remember, even though additional earnings may be mostly capital gains, the IRS treats all gains inside an IRA as income and will tax any amount above your total contributions at your income tax rate for non-qualified distributions. For example, let's look at the taxes and penalties for withdrawing ​$11,000​ from an IRA to make a down payment on your first home.

If you are withdrawing from a Roth IRA and have contributed ​$10,000​, then the first ​$10,000​ is tax-free. You must pay income tax on the final ​$1,000​ of the withdrawal, plus the ​10 percent​ penalty. If you are in the ​24 percent​ tax bracket, you owe the IRS ​$340​ out of the ​$11,000​ withdrawal.

Using the same example, if you were withdrawing from a traditional IRA, then you would still owe the ​$340​ – plus ​$2,400​ in taxes on the penalty-free portion of ​$10,000​. The costs of withdrawing from a traditional IRA can add up very quickly.