If you've already started putting away money in an IRA, congratulations -- you’re well on your way toward enjoying a more comfortable retirement. The tax deferral of your investment returns in an IRA can add significant value to the money you save. IRAs are generally designed for long-term retirement savings, but you may sometimes encounter a situation calling for emergency funds. If you’re considering cashing out your IRA money, make sure you understand what taxes and penalties you’re in for.
Depending on which IRA you have, you may have to pay tax at ordinary income rates on all or a portion of your withdrawal. Contributions to a traditional IRA are tax-deductible, but you pay tax on all funds that you withdraw. Because contributions to a Roth IRA are made with after-tax income, qualified distributions are not taxed. A qualified distribution is a withdrawal made after the account is 5 years old under one of the following additional circumstances:
-- You are 59 1/2 years old; -- The withdrawal is taken in connection with a disability; -- The distribution is paid to a beneficiary or to your estate after your death; or -- The money -- up to a lifetime limit up to $10,000 -- is to be used to buy, build or improve your first home.
If your withdrawal is not a qualified distribution, you’ll pay tax only on the investment growth portion of the withdrawal.
Even if your Roth IRA withdrawals don’t qualify as tax-free, the rules say you have to withdraw your money in a particular order. First you take out your contributions, which are not taxable. Second you take out any money you previously rolled over or transferred to your Roth IRA. Of those funds, the taxable portion comes out first, followed by the nontaxable portion. Finally you take out the earnings on the contributions. So if you don’t completely cash out your IRA but take a partial withdrawal, chances are you’ll limit your tax exposure.
If you cash out either type of IRA before you’re age 59 1/2, the IRS will charge you a penalty tax of 10 percent on top of any income taxes payable. On a traditional IRA the penalty tax applies to all withdrawals. On a Roth IRA, the penalty tax applies to the taxable portion of a nonqualified distribution. In the case of either type of IRA, you don’t have to pay that penalty tax if you qualify as a first-time home buyer. Also, you may not have to pay the penalty under certain other conditions, like you have unreimbursed medical expenses, you’re using the money for medical insurance premiums or using it to pay qualified higher education costs. You also don’t have to pay the penalty if you're a qualified reservist.
First Home Advantage
If you use a withdrawal from your Roth IRA to buy, build or rebuild your first home, you won’t have to pay the 10 percent penalty tax on the withdrawal, even if the withdrawal is not a qualified distribution and you had to pay taxes on the investment growth portion of the withdrawal. Wait five years after setting up your Roth IRA to take money out and the distribution becomes qualified and you pay no tax at all. There are some conditions to satisfy, however. You have to be a first-time home buyer, meaning you and your spouse did not own a home in the previous two years. You can each withdraw up to $10,000 lifetime and the money must be used to pay qualified acquisition costs up to 120 days after you receive the money. Qualified acquisition costs can include your mortgage down payment or any other costs associated with buying, building or improving your first home.]
Philippe Lanctot started writing for business trade publications in 1990. He has contributed copy for the "Canadian Insurance Journal" and has been the co-author of text for life insurance company marketing guides. He holds a Bachelor of Science in mathematics from the University of Montreal with a minor in English.