Withdrawals from an Individual Retirement Account (IRA) may be withdrawn for certain emergencies before retirement age. Although an individual may withdraw money from an IRA at any time, that withdrawal may trigger an income tax liability on the amount withdrawn (except for some Roth IRAs) and a 10% penalty unless an exception to the rule is met. From an investment point of view, funds from an IRA should be the last nest egg you touch unless the 10% penalty can be avoided.
Planning early distributions (before age 59½) from an IRA to take advantage of the exceptions to the 10% additional tax penalty allows IRAs to double up as tax-preferred emergency savings funds. In addition, familiarity with specific rules for the various exceptions can help you avoid falling into any unexpected penalty traps.
Several new exceptions to the 10% penalty have been created in recent years. Most of these exceptions apply to both traditional IRAs and Roth IRAs. For example, the penalty does not apply to certain distributions from a traditional or Roth IRA for qualified first-time home buyers.
Withdrawals from traditional IRAs and Roth IRAs are taxed differently since the 10% penalty only applies to the portion of the distribution subject to income tax (except for amounts attributable to Roth conversions within five years):
- For a traditional IRA, distributions are taxed different when coming from contributions or earnings. Only the portion of a distribution attributable to nondeductible contributions is not taxed, while the portion of the distribution attributable to deductible contributions is treated the same as earnings.
- For a Roth IRA, distributions are first deemed to be paid out of contributions, which are nondeductible (or already taxed in the case of a rollover situation). Therefore, substantial withdrawals may be made for any reason from Roth IRAs without tax or penalty.
The exceptions: The 10% penalty will not be assessed on an IRA distribution to the extent that any of the following exceptions apply:
- On or after reaching age 59½ by the IRA owner (traditional or Roth IRA; also exempt from income in Roth IRA).
- On or after the death of the IRA owner (traditional or Roth IRA; also exempt from income in Roth IRA).
- After disability of the IRA owner (traditional or Roth IRA; also exempt from income in Roth IRA).
- Qualified first-time home buyers up to $10,000 (traditional or Roth IRA; also exempt from income in Roth IRA).
- Qualified higher education expenses (traditional or Roth IRA).
- Deductible medical expenses (traditional or Roth IRA).
- Health insurance premium distributions to certain unemployed owners (traditional or Roth IRA).
- A series of substantially equal periodic payments, made at least annually, to a traditional IRA owner (inapplicable to Roth IRAs).
The general rule of thumb on IRA withdrawals is that a taxpayer should contribute only those funds that he or she will not touch under any circumstances. However, if emergencies arise it will be up to you, rather than Uncle Sam, to make the decision on the trade off between keeping funds for retirement and using them for certain other important lifetime events.
If you have any further questions on IRA withdrawals, please contact Henssler Financial at 770-429-9166 or experts@henssler.com.
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