The government created individual retirement accounts to encourage saving for retirement. However, you're allowed to remove the money whenever you want for whatever reason you want. Although you can liquidate your IRA at any time, you can't always get the money out penalty-free and you might find yourself owing income taxes you wouldn't have otherwise had to pay.
Early Withdrawal Penalties
On top of any income taxes, you'll also owe a 10 percent early withdrawal penalty when you liquidate your IRA with a non-qualified withdrawal. For example, if you liquidate your IRA worth $20,000 and $8,000 of the distribution is taxable, you'll owe an extra $800 when you file your taxes unless an exception applies. Exceptions include a permanent disability, up to $10,000 for a first house, medical expenses exceeding 7.5 percent of your adjusted gross income and higher education expenses.
Traditional IRA Taxes
Unless you're 59 1/2, you won't be liquidating your traditional IRA with a qualified withdrawal. The ordinary income taxes are the same for nonqualified distributions as with qualified distributions, the extra 10 percent penalty is the difference. As a result, unless you've made nondeductible contributions, the entire liquidation counts as taxable income. If you have made nondeductible contributions, you get that amount out tax-free. For example, say your traditional IRA is worth $18,000 and contains $3,000 of nondeductible contributions: $15,000 is taxable and $3,000 is tax-free. (ref 1, p. 38)
Roth IRA Taxes
There are two requirements for qualified distributions from Roth IRAs. First, at least five years must have passed since the first day of the first tax year a contribution was made. Second, you must be either 59 1/2, permanently disabled, using the withdrawal (up to $10,000) for a first home or taking distributions from an inherited Roth IRA. If you meet those conditions, your entire liquidation is tax-free. If you do not, you'll get your contributions tax-free, but the earnings count as taxable income.
When you liquidate your IRA, you receive a Form 1099-R that shows you how much you took out. You must use Form 1040 or Form 1040A to file your taxes. If you're liquidating a traditional IRA containing nondeductible contributions or liquidating a Roth IRA, you must use Form 8606 to figure the taxable portion of the distribution. If any of the distribution is taxable, you must also use Form 5329 to calculate your early withdrawal penalty.
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