When you take money out of an IRA, you pay income tax on it. When you withdraw money early -- before 59 1/2, according to federal law -- you generally pay an added 10 percent tax penalty. There are a few circumstances in which you can duck either the income tax or the penalty on an early withdrawal.
If you transfer money from one IRA to another, you don't pay any tax at all as you're not withdrawing the money to keep. The account trustee can make the transfer, or you can take out the money and roll it over to the new account yourself. Trustee transfers are a safer option: If you don't complete a rollover within 60 days, the IRS will tax you on everything you took out, plus penalties.
If you withdraw money early for an IRS-sanctioned reason, you don't have to pay the penalty, just the regular income tax. Among the acceptable reasons for taking a tax-free withdrawal; to build or buy a first home (up to $10,000); to help cover your or your family's college expenses or your medical bills, if your medical costs are greater than 7.5 percent of your adjusted gross income. There's no penalty if you take money out after you have become disabled.
The normal annual limit for contributing to an IRA is $5,000. If you have a high adjusted gross income -- the income figure at the bottom of the first page of your 1040 tax return -- and a workplace retirement plan, the amount you can contribute tax-free goes down. You pay tax on any contributions above that, but when you take out those contributions, the withdrawal is tax-free. If 40 percent of your account comes from after-tax dollars, 40 percent of your early withdrawal is exempt from income tax. You will, however, have to pay the 10 percent penalty on the whole amount.
If you screw up and contribute more than the maximum to your IRA, you pay a 6 percent penalty tax on the excess contribution if you leave it in the account. Withdrawing the money cancels the penalty. If you already claimed the excess as tax-deductible, you have to report the withdrawal to the IRS and pay tax -- but otherwise, you don't count it as taxable income. You don't pay the 10 percent penalty on this sort of withdrawal, regardless of your age. In general, you can withdraw money from your IRA tax free and penalty free in order to pay any IRS payments that have been levied against it, and you won't pay taxes or penalties on money you are required to withdraw from your account to give to an ex-spouse as part of a divorce decree.
A graduate of Oberlin College, Fraser Sherman began writing in 1981. Since then he's researched and written newspaper and magazine stories on city government, court cases, business, real estate and finance, the uses of new technologies and film history. Sherman has worked for more than a decade as a newspaper reporter, and his magazine articles have been published in "Newsweek," "Air & Space," "Backpacker" and "Boys' Life." Sherman is also the author of three film reference books, with a fourth currently under way.