While stopping contributions to an IRA can stunt its growth, dipping into it early can have an even greater negative effect. And what if you empty it out? Well, in terms of gaining the greatest benefit from your earnings, that's probably not a good idea.
Even so, withdrawing cash from an IRA is sometimes necessary. For instance, in 2020, the Coronavirus Aid, Relief and Economic Security (CARES) Act allowed some individuals to make penalty-free withdrawals from tax-advantaged retirement plans including traditional IRA accounts. In just 91 days, 3 percent of Fidelity Investment's eligible plan participants withdrew an average of $12,100 each.
Before you too respond to an economic uncertainty by drawing from an IRA, you should consider the facts.
IRA Withdrawal Rules
When you make a tax-free contribution to an individual retirement account, that cash grows in the account tax free. When you withdraw the money at age 59 ½ or later, it's taxed.
If you make a premature account withdrawal – a withdrawal before you reach the age of 59 ½ – you must include the amount of the withdrawal in your gross income for income tax purposes and you incur a 10 percent early withdrawal tax penalty, unless you qualify for an exception to the tax.
Read More: Penalty for Early Withdrawal of an IRA
IRA Hardship Withdrawal
There are exceptions to the 10 percent early withdrawal tax penalty rule such as using IRA funds to pay your medical insurance premium after a job loss. Other hardships that don't trigger the 10 percent tax penalty include avoiding foreclosure, home repairs after a disaster and medical expenses.
Hardship Withdrawal and the CARES Act
What's more, this temporary change to the rules allows a qualified individual to pay back the IRA account distribution. Otherwise, the account owner must treat one-third of the cash withdrawal as taxable income when preparing tax returns for the next three years.
Qualification for Hardship Withdrawal
In addition, as the account owner, you must meet certain criteria, which include:
- A COVID-19 diagnosis for you, your spouse or a dependent with a CDC-approved test.
- Financial hardship due to COVID-19 conditions such as a delay in starting a new job, a withdrawn job offer, a layoff, a quarantine, a reduction in pay, a reduction in hours, a reduction in self-employment income, the closure of your business, a reduction in your business, a lack of childcare that makes you unable to work, or another Department of Treasury-defined event.
Amount of IRA Hardship Withdrawal
Normally, the cash you withdraw from your IRA due to a hardship must be limited to the amount needed to satisfy that financial need. Any withdrawal that exceeds that amount is subject to a 10 percent early withdrawal penalty.
In 2020, if your IRA withdrawal qualifies as a hardship withdrawal under the CARES Act, you can make one or more penalty-free withdrawals, from one or more IRA accounts, up to a maximum of $100,000 per person. Any withdrawal that exceeds the $100,000 per person maximum is subject to a 10 percent early withdrawal penalty.
Tax and IRA Hardship Withdrawal
The Employee Retirement Income Security Act (ERISA ) does not require a financial institution to withhold a percentage of an IRA withdrawal as an advance payment on taxes you may owe on that withdrawal. IRA withdrawals that you do not repay, however, are not exempt from taxes.
In most circumstances, if you make an early withdrawal from an IRA before age 59 1/2, you must include the withdrawal in your taxable gross income and incur a 10 percent tax penalty. Under the CARES Act, if you make an early withdrawal(s) from an IRA before age 59 1/2 and don't recontribute the early distribution(s), you must include the withdrawal(s) in your taxable gross income and incur a 10 percent tax penalty.
Recontribution and Early Distribution
Typically, if you make an early withdrawal from an IRA before age 59 1/2, you don't have an opportunity to recontribute the early distribution to your account. Instead, you include the withdrawal in your taxable gross income and incur a 10 percent tax penalty.
Under the CARES Act, the IRS grants you a three-year period during which you can recontribute some or all of your CARES Act-related IRA withdrawal(s.) If need be, you can file an amended return(s) to account for the recontribution(s.) So, if an IRA hardship withdrawal is a large one, consider setting aside the funds needed to pay the tax you will owe in the future.
Visit IRS.gov and search for "Free Tax Return Preparation for Qualifying Taxpayers" to find out if you quality for free help filing your tax return.
- The U.S. Department of the Treasury: The CARES Act Works for All Americans
- Associated Press: Fidelity® Q2 2020 Retirement Analysis: Steady Contributions Combined With Market Performance Lead to Double-Digit Rebound Across Retirement Account Balances
- Internal Revenue Service: What If I Withdraw Money From My IRA?
- Internal Revenue Service: Coronavirus-related relief for retirement plans and IRAs questions and answers
- Consumer Financial Protection Bureau: Considering an Early Retirement Withdrawal? CARES Act Rules and What You Should Know
- Internal Revenue Service: Hardships, Early Withdrawals and Loans
- Internal Revenue Service: Retirement Topics - Exceptions to Tax on Early Distributions
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.