As with all investments, when you place money in an IRA, you expect to someday access it. Unlike other investments, the Internal Revenue Service’s rules about taxing distributions – its term for any withdrawal from your IRA – are somewhat complicated, and the tax you should expect to pay if you liquidate your IRA depends upon the type of IRA, your age at the time of liquidation and other situations in your life.
The IRS considers any distribution from your Roth or traditional IRA a qualified distribution if you make it after you turn 59 1/2 or meet exemptions to its early distribution rules. Because earnings you place in a traditional IRA are tax-deferred, if you liquidate a traditional IRA, even if it’s a qualified distribution, expect to pay tax on the entire amount as if it was ordinary income. If your IRA’s balance is large, the distribution may push you into a higher tax bracket, raising your marginal rate. You pay income taxes on funds contributed to Roth IRAs when you contribute, so you can receive any qualified distribution from a Roth completely tax free.
The IRS intends traditional and Roth IRAs to be used in retirement and penalizes investors who take distributions from the accounts before they reach retirement age of 59 1/2 years. In most cases, if you liquidate your IRA before you reach retirement age, the IRS considers it an unqualified distribution. In addition to any income taxes you may owe on the distribution, the IRS assesses a 10 percent early distribution penalty. This penalty applies to traditional and Roth IRAs alike.
Exemptions to Early Distribution Penalty
In some circumstances, you may receive distributions from an IRA before you turn 59 1/2 and not face the early distribution penalty. You may take penalty-free early distributions from an IRA if you’re disabled and can’t work or if you are unemployed and using it to pay for health insurance. You can also use it to cover unreimbursed medical bills, pay for qualified education expenses or pay for your first home. Except for the disability exemption, all exemptions from the penalty are limited to actual costs of bills or, in the case of the first-time homebuyer exemption, $10,000, so liquidating a large IRA may still trigger an early distribution penalty even if you qualify for an exemption.
John has a traditional and Roth IRA, each with a balance of $100,000. He’s age 58 and in the 35 percent tax bracket when he liquidates both. This incurs an 10 percent early distribution penalty on the transactions. After taxes, he receives $90,000 from the Roth. His after-tax proceeds from his traditional IRA are $55,000, or $100,000 less the 35 percent tax and the 10 percent early distribution penalty. If he waits until he reaches retirement age to liquidate the accounts, he’ll receive the full balance of his Roth and $65,000 from his traditional IRA, assuming he’s still in the 35 percent tax bracket.
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