The Internal Revenue Service offers tax advantages for money in retirement accounts as a way to entice citizens to take the initiative and save for the future. Because the tax benefits may be potentially significant, the IRS restricts withdrawals from these accounts until you reach age 59 1/2. If you withdraw funds earlier, even a partial lump sum, you'll generally be charged a penalty as well as income tax on the withdrawal.
A payout from a qualified retirement account, such as a traditional IRA, creates income tax liability, even if you withdraw only a partial lump sum. Contributions to traditional IRAs are made with pre-tax dollars, which means you can claim a deduction for the contribution on your income tax return. Every dollar withdrawn from an IRA is added to your taxable earnings for that year.
Deposits into non-qualified retirement accounts, such as Roth IRAs and annuities, are made with after-tax dollars, so you’ll only owe income tax on the amount withdrawn that represents growth; the remainder, representing your after-tax contributions, may be withdrawn tax-free. Most non-qualified retirement investment vehicles follow the Last-In-First-Out (LIFO) methodology in which the money most recently added to the account is the first withdrawn. Therefore, a partial lump sum withdrawal may be taxable unless it exceeds the growth and includes some of your initial deposit money.
If you choose to withdraw money from your retirement account before age 59 1/2, the IRS will penalize you for the early withdrawal. In addition to owing ordinary income tax on the previously untaxed portion of the distribution, you will owe an additional 10 percent penalty on the amount withdrawn.
In some instances, you may be entitled to an exemption from the 10 percent early withdrawal penalty. The qualifying exceptions are listed in IRS Publication 590. Typically, if you withdraw money from your retirement account to pay for a first home, excess medical expenses or college tuition, the distribution may not be subject to the early withdrawal penalty, although you will still owe ordinary income tax on the amount withdrawn.