Technically speaking, you can cash out your traditional IRA any time you want and the Internal Revenue Service won't stop you. But Uncle Sam discourages you (and pads his own wallet) by penalizing any early withdrawals, unless an exception applies. There's no such thing as a hardship withdrawal exception, so no matter how much you need the money, you're stuck with the penalty unless you qualify for a specific exception.
A 10 percent penalty kicks in when you take money from your traditional IRA before you reach age 59 1/2. That is on top of income taxes at your regular rate on the amount withdrawn. For example, if you take a $10,000 taxable traditional IRA withdrawal when you're 40, you owe income taxes and a $1,000 penalty.
Taxable Portion Only
The penalty applies only to the taxable portion of your traditional IRA withdrawal. If you haven't made any nondeductible contributions, your entire withdrawal is taxable. On the other hand, if your traditional IRA does contain nondeductible contributions, your withdrawal gets prorated -- split proportionately between nondeductible contributions and the rest of your account. For example, say you have $9,500 of nondeductible contributions in your traditional IRA and it is worth $95,000. Because 10 percent of your traditional IRA is nondeductible, 10 percent of your early withdrawal comes out tax-free and penalty-free.
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The IRS does provide several exceptions that let you avoid some or all of the penalty. For example, if you become permanently disabled, you can take out as much as you want without paying the penalty. You can also take out money to pay for post-secondary education, medical insurance premiums when you're unemployed and significant medical expenses -- but only to the extent of your qualifying expenses. You can also take out up to $10,000 to buy your first home.
Whether you qualify for an exception or not, you must report the withdrawal on Form 1040 -- the longest tax form -- and you have to attach Form 5329. Form 5329 calculates the penalty or reports your exception. You don't send in any supporting documentation with the form, such as your medical bills or tuition statement from your child's college, but you should keep records just in case the IRS questions your return.
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