The Internal Revenue Service doesn’t have formal hardship rules for early distributions from individual retirement accounts. Consequently, you don’t have to prove financial hardship. You can take money out at any time, but you’ll usually be penalized for early withdrawals. However, the IRS has a list of exceptions that serve the same function as hardship rules in that they allow penalty-free early withdrawals under certain circumstances.
Traditional IRA Early Distributions
The IRS imposes a penalty tax of 10 percent on top of income taxes due when you withdraw traditional IRA funds before age 59 1/2.. Since people sometimes face unexpected financial difficulties, the IRS makes exceptions to the penalty rule when you use the money for certain purposes. If you take out more than you need to pay hardship expenses, the excess amount is subject to the penalty. Suppose you withdraw $10,000 to pay medical bills and $2,500 to cover income taxes on the withdrawal. The extra $2,500 is subject to the penalty tax.
Penalty Tax Exceptions
Some exceptions to the early withdrawal penalty are health-related. You can pull money out penalty free if you become permanently disabled or to pay unreimbursed medical expenses in excess of 10 percent of your adjusted gross income. You may use IRA money to cover health insurance premiums when you are unemployed. Withdrawing IRA funds for purchasing or making improvements to a first home or to cover higher education costs isn’t penalized. Annuity payments and money you use to pay an IRS levy are exempt from the penalty tax. Qualified distributions you make as a reservist on active duty are penalty-free. Finally, if you inherit an IRA, the penalty tax does not apply. In all cases, you are liable for any income taxes due on the withdrawn funds.
Roth IRA Qualified Distributions
Early withdrawal rules work differently for Roth IRAs and vary depending on whether or not the distribution is qualified. You pay no penalty tax or income taxes on qualified Roth distributions. Normally, Roth IRAs must be five calendar years old and you must be 59 1/2 years old for a withdrawal to be qualified. There are three early withdrawal exceptions. Provided the five-year rule is satisfied, an early distribution from a Roth is qualified if you inherited the IRA, if you become disabled or when you use up to $10,000 for buying or fixing a first home.
Roth IRA Unqualified Distributions
The tax consequences of unqualified Roth withdrawals depend on how the withdrawn funds are categorized. There’s never any tax on withdrawals of contributed money. Funds you pull from a Roth are considered contributed up to the amount of your contributions to the Roth to date.
Rollovers come next. Rollovers dollars in Roth IRAs aren’t subject to income taxes. However, the money must stay in the Roth for five years or until you are 59 1/2. Otherwise you pay the 10 percent penalty unless an exception applies.
Investment earnings taken out of a Roth IRA early are subject to the rules for traditional IRAs. You must pay income taxes on the money. Unless the withdrawal is exempt because of an exception, you also pay the penalty tax.
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