I need cash. How bad is it to take money out of my IRA?

All the free money from the government has been spent and inflation has skyrocketed. You are now facing a brutal cash deficit. What to do?

One possible solution is to withdraw your IRA early. By early retirement, I mean one that occurs before the age of 59 and a half. Needless to say, there are implications for the federal income tax, including the possibility of staying with the dreaded 10% early retirement penalty tax. Here’s what you need to know to make an informed decision.

Early withdrawals from an IRA are usually taxable, but a penalty tax can often be avoided

In almost all cases, all or part of any withdrawal from a traditional IRA will count as taxable gross income. The taxable percentage depends on whether you made a non-deductible contribution to your account.

If you do, each withdrawal will be a proportional amount of your total non-deductible contributions, and this portion is tax-free.

The proportional part of each withdrawal consisting of deductible contributions and accrued income is subject to tax. If you have never made a non-deductible contribution, 100% of any withdrawals are subject to tax.

While it may be impossible to avoid generating taxable income by making a withdrawal before the age of 59 and a half, you may be able to avoid the 10% penalty on early withdrawals by taking advantage of the exceptions below. Please keep reading.

Penalty tax exceptions for early withdrawals from traditional IRAs

The following exceptions to the 10% federal penalty tax are available for early withdrawals (before the age of 59 and a half) from traditional IRAs, which for this purpose include Simplified Employee Pension Accounts (SEP-IRA) and SIMPLE-IRA accounts.

1. Substantially Equal Periodic Payments (SEPP)

These are annuities similar to an annuity that must be made for at least five years or up to 59 and a half years, whichever happens. later. The rules for SEPPs are complicated. You may want to involve your tax advisor to avoid inconvenience.

2. Withdrawals for medical expenses

If you have qualified medical expenses in excess of 7.5% of adjusted gross income (AGI), early withdrawals from the IRA up to the amount of the excess are exempt from the 10% penalty tax. However, medical expenses must be paid in the same year as the early withdrawal.

3. Withdrawals for qualified higher education expenses

Early withdrawals from the IRA are free of penalties to the extent of qualified higher education expenses paid during the same year. Qualified expenses must be for the education of: (1) the account owner or spouse of the account holder or (2) an adopted child, stepchild, or child of the account holder or spouse of the account holder.

4. Discharges to pay health insurance premiums during unemployment

This exception is available to an IRA homeowner who has received unemployment compensation payments for 12 consecutive weeks under any federal or state unemployment compensation law during that year or the year before. If this condition is met, early withdrawals from the IRA owner during the year in question are free of penalty up to the amount paid during that year for health insurance premiums to cover the account owner, spouse and dependent people. However, early withdrawals after the account owner has resumed work for at least 60 days do not meet the requirements for this exception.

5. Discharges due to births or adoptions

Sanction-free treatment for a qualified distribution of birth or adoption (withdrawal). This means a distribution made during the one-year period beginning on the date an eligible child of the account owner is born or the date on which the legal adoption of an eligible adoptee of the account owner ends. An eligible adoptee means any person (other than a child of the spouse of the account holder) who is under the age of 18 or who is physically or mentally incapable of supporting himself or herself. The maximum distribution of a qualified birth or adoption without penalty for any eligible birth or adoption is $ 5,000, and this limit appears to apply individually. Therefore, when both members of a married couple have eligible retirement accounts, each spouse can apparently receive a qualifying distribution of $ 5,000 per birth or adoption without penalty.

6. Withdrawal of purchases for the first time ($ 10,000 lifetime limit)

This exception allows the withdrawal of the IRA without penalties to the extent of the money spent by the account owner within 120 days to pay the qualifying acquisition costs of a primary residence. However, there is a $ 10,000 lifetime limit on this exception. The principal residence may be acquired by: (1) the account holder or the spouse of the account holder; (2) the account owner’s child, grandchild, or grandparent; or (3) the spouse’s child, grandchild or grandparent. The buyer of the primary residence (and the spouse if the buyer is married) must not have had a current interest in a primary residence within the two-year period ending on the date of acquisition. Qualified acquisition costs are defined as the costs of acquiring, building, or rebuilding a primary residence, including closing costs.

7. Withdrawal of military reservists called to active duty

This exception applies to certain early withdrawals from the IRA made by members of the military reserve who are called up for active service for at least 180 days or for an indefinite period.

8. Discharges after disability

This exception applies to amounts paid to an IRA owner who is physically or mentally disabled to the extent that he or she is unable to engage in his or her usual gainful activity or comparable gainful activity. In addition, the disability should be expected to: (1) cause death or (2) be of long or indefinite duration. However, it is not necessary to wait for the disability to be permanent to meet the above requirement.

9. Withdrawals to meet IRS fees

This exception applies to early withdrawals from the IRA made to pay IRS taxes to the account. However, this exception is not available when the IRS charges the owner of the IRA (as opposed to the IRA itself) and the owner withdraws the funds from the IRA to pay the tax.

10. Withdrawal after death

Amounts withdrawn from an IRA after the death of the account owner are always exempt from the 10% penalty tax. However, this exception is not available for funds transferred to the IRA from a surviving spouse or if the surviving spouse decides to treat the inherited IRA as his or her own account. If the surviving spouse needs some of the inherited funds, they must be left to the inherited IRA (i.e., what is still considered to have been created for the deceased spouse). The surviving spouse can then withdraw the necessary funds from the inherited IRA without any 10% penalty tax, thanks to this exception.

What about an early Roth IRA withdrawal?

Immediate tax results are likely to be better for an early withdrawal from the Roth IRA (before age 59 and a half) than for an early withdrawal from the traditional IRA. This is because you will not owe any federal income tax on early withdrawals that consist of annual Roth IRA contributions or contributions to convert a traditional IRA into a Roth state. These federal income tax-free dollars are considered to come out of the account first.

Under a weird but true rule, you could owe a 10% early retirement penalty tax, but no federal income tax, on withdrawals that consist of conversion contribution dollars. But you only need to pay the penalty tax if the withdrawal occurs within five years of the conversion contribution. And all the exceptions to the 10% penalty tax explained in the context of early withdrawals from traditional IRAs apply equally here.

After you have withdrawn all dollars from your annual contribution and conversion contribution, what’s left in your Roth account is your account earnings. Withdrawals from account earnings are fully taxable unless you have at least one Roth account open for more than five years and are 59 and a half years old or older.

For full details on how Roth withdrawals are taxed, see this previous Tax Guy column.

The bottom line: Early withdrawals from an IRA should be the last resort

As explained, most or all of an early withdrawal from the traditional IRA will likely be taxable. And the withdrawal could push you to a higher level of federal federal income tax. You will probably also have to pay the 10% early retirement penalty tax and perhaps also the state income tax. And, the only way to replace the money extracted from your traditional IRA is by making future contributions to fill the deposit. This could take many years. In the meantime, you have less money to invest with deferred taxes.

The immediate tax consequences of making early withdrawals from the Roth IRA are often less severe. But again, it could take years for future contributions to return to the starting point, and the end result will be less federal tax-free money available when you reach retirement age.

For all these reasons, making an early withdrawal from the IRA to resolve a cash crisis should be the last resort. Unfortunately, this is sometimes the only option.

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