Congress designed individual retirement accounts (also known as individual retirement arrangements or IRAs) to encourage workers to save some of their earnings for retirement. This design uses a carrot-and-stick approach: The carrots are tax breaks for contributions, and the sticks are tax penalties for withdrawing money from an IRA early. You can avoid early withdrawal penalties under specific circumstances, one of which relates to your employment status.
When You Can Withdraw From an IRA
You can take money from your IRA at any time. However, if you do so before age 59 1/2, the IRS says you may have to pay an early distribution penalty and income tax on the withdrawn amount. The withdrawal rules differ for the two types of IRA accounts:
- Traditional IRAs: Generally, you must include withdrawn money and assets in your annual taxable income. Early distributions trigger an additional 10 percent tax unless you qualify for any of the 10 permitted exceptions.
- Roth IRAs: You never pay taxes or penalties when withdrawing contributions from a Roth IRA. However, you must pay taxes and may have to pay a 10 percent penalty on early distributions of earnings. A Roth distribution is early if it occurs before age 59 1/2 or within a five-year period beginning with the tax year of the initial contribution. The 10 exceptions apply to the 10 percent penalty for early-age withdrawals, but the five-year rule does not permit any exceptions.
Typically, you request an IRA distribution by filling out an online or paper form provided by the account custodian. Carefully indicate whether the distribution is a withdrawal or a tax-free rollover to another retirement account. Also, specify whether any penalty exceptions apply and any amount you’d like withheld. It may take several days for your money to arrive, either by check or transfer to another of your accounts.
The Unemployment Exception
One way you can avoid the distribution penalty for withdrawals before age 59 1/2 is by meeting five requirements related to employment:
- You had a job and lost it.
- You received federal or state unemployment benefits for 12 consecutive weeks due to your job loss.
- You withdrew IRA money during the year you collected unemployment benefits or the following year.
- Your IRA withdrawals occurred no more than 60 days after you returned to work.
- The withdrawn amount does not exceed the medical insurance premiums you paid during the year for yourself, your spouse and your dependents. Any withdrawn amount exceeding your premiums is subject to taxes and penalties unless another exception applies.
Reporting the Income Tax
Your IRA custodian will send you IRS Form 1099-R in January following the year of the IRA withdrawal. The form reports the taxable or total amount of your withdrawals for the year and any federal income tax withheld. Form 1099-R includes a distribution code. A code of 1 denotes early distribution.
Enter the total and taxable amounts of your IRA distributions for the year, as reported by Form 1099-R, onto the “IRA distributions” line of Form 1040 (or one of its variants).
Reporting the Distribution Penalty
You may need to file IRS Form 5329 to report early distributions. You don’t need the form if your 1099-R correctly indicates distribution code 1 – you simply multiply the taxable portion of the early distribution by 10 percent and record the result on Schedule 2 of Form 1040.
Otherwise, complete Form 5329, transfer the penalty to Schedule 2 and include both forms in your tax return. Upon completing Schedule 2, transfer the total to the “Other taxes” line of Form 1040.
Impact on Unemployment Benefits
IRA withdrawals do not reduce your unemployment benefits. In contrast, the portion of a 401(k) distribution ascribed to employer contributions does reduce the unemployment benefits you receive.
If you lose your job, you have the right to roll your 401(k) to a traditional IRA tax-free. You can then withdraw money from your IRA without reducing your unemployment benefits.
- Ask your financial institution to transfer your IRA money to a checking or savings account. Carrying around your IRA money or keeping the money at your home is not safe.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.