Does an Early IRA Withdrawal Affect or Count for Income Tax Purposes?

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 age59 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 percentearly withdrawal tax penalty, unless you qualify for an exception to the tax.

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

According to the ​2020 CARES Act,​ a qualified individual, who is under the age of 59 1/2, can take a tax-favored distribution from an IRA account between ​Jan. 1, 2020 and Dec. 30, 2020.

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 normal circumstances, the IRS says a hardship withdrawal is one that imposes an immediate and heavy financial burden.

To qualify as a hardship withdrawal under the CARES Act, the distribution must be made from an eligible retirement plan to a qualified person during the period Jan. 1, 2020 to Dec. 30, 2020.

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.