An Individual Retirement Account, commonly known as an IRA, is a type of tax-deferred retirement savings account. You make pretax contributions to your IRA during your working years, and the funds in your account continue to grow tax free until withdrawal. If you choose to withdraw funds before the legally mandated retirement age, you are assessed a 10 percent early withdrawal penalty, as well as applicable taxes (with certain exceptions).
You can only contribute up to a specific amount to an IRA every year. In 2010, the annual contribution limit to an IRA is $5,000, plus an additional $1,000 for those 50 or older.
IRA Distributions (Withdrawals)
At age 59 1/2 you can take distributions from your IRA with no penalties, and the amount withdrawn is treated as ordinary income that year for income tax purposes. If you choose to take a distribution from your IRA prior to age 59 1/2, you will be assessed a 10 percent early withdrawal penalty. For example, for a $5,000 distribution from your IRA, you will be assessed a $500 early withdrawal penalty (and a minimum of 15 percent will also be withheld for income taxes in most cases).
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Exceptions to IRA Early Withdrawal Penalty
The IRS outlines eight exceptions to the early withdrawal penalty where you can make withdrawals from your IRA without being assessed the 10 percent penalty:
1. Rollover into another qualified plan; 2. Non-reimbursed medical expenses (if your medical expenses were more than 7.5 percent of your adjusted gross income for that year); 3. Health insurance (if you lost your job, received unemployment benefits and are paying for health insurance for yourself and/or your family); 4. Disability; 5. Higher education expenses; 6. First time homeowner (limited to $10,000, and must be withdrawn no more than 120 days after purchasing the home); 7. Beneficiary of an IRA (no early withdrawal penalty for beneficiaries of an IRA owner who dies before age 59 1/2)
Exception for Substantially Equal Periodic Payments
- You can make penalty-free withdrawals from an IRA that are structured as a series of substantially equal periodic withdrawals made over your lifetime. The IRS has a formula to calculate these withdrawals. These substantially equal periodic payments must last for at least five years or until you reach age 59 1/2, whichever is longer (for example, if you start taking equal payments when you turn 56, then you must continue until at least age 61).
Minimum Required Distributions (MRDs)
Beginning the year you turn 70 1/2, IRA holders must begin taking Minimum Required Distributions. The IRS has a life expectancy formula to calculate MRDs based on your age and the amount in your IRA. The only common exception to MRDs is if you're age 70 1/2, you're still working and you are not a 5 percent owner of the company you are working for, then you may not have to take MRDs. However, keep in mind that this exception only applies as long as you are working.