Early Withdrawal Penalties for Traditional and Roth IRAs

Early distributions from individual retirement accounts (IRAs) are made before you reach age 59½. This is something most financial experts say is rarely (if ever) a good idea. That's because early IRA withdrawals put a dent in future earnings and come with a high cost: a 10% tax penalty plus any income tax you may owe on the distribution. The Internal Revenue Service (IRS) imposes the penalty to dissuade IRA holders from using their savings before retirement. But the penalty only applies if you withdraw taxable funds.

What Are the Early Withdrawal Penalties for IRAs?

As noted above, it's never really a good idea to make early withdrawals from your IRAs. But you may have no choice. For instance, you may have a medical emergency, need to pay educational bills, want to buy a new home, or are struggling financially. Whatever the reason, it's important to know what the implications are and how they can affect you.

Roth IRAs

Contributions to Roth IRAs are made using after-tax dollars. This means that you pay income tax on your contributions for the year when you make them. As a result, withdrawals of Roth contributions are not subject to income tax, as this would be double taxation.

If you take out an amount equivalent to the sum that you put into your Roth, the distribution is not considered taxable income, regardless of your age, nor is it subject to penalty.

But if you withdraw an amount above that (meaning that you start dipping into the account’s earnings), that amount is generally considered taxable income. It also may be subject to the 10% early distribution penalty and the money would be treated as income.

Traditional IRAs

Early distributions from traditional IRAs generally incur heavy penalties. Contributions to this type of account are made with pretax dollars. Your contributions are subtracted from your taxable income for the year, effectively reducing the amount of income tax that you owe.

This means you get an up-front tax break when you contribute to a traditional IRA, but you’ll pay taxes on your withdrawals in retirement. This generally means that your entire traditional IRA balance is composed of taxable income. So if you withdraw funds before age 59½, the 10% tax penalty likely applies to the full amount of the distribution.

To calculate the penalty on an early withdrawal, multiply the taxable distribution amount by 10%. For example, an early distribution of $10,000 would incur a $1,000 tax penalty and would be treated (and taxed) as additional income.

Early Withdrawals From Roth IRAs

Qualified distributions from a Roth IRA are tax- and penalty-free. The IRS considers a distribution to be qualified if it has been at least five years since you first contributed to a Roth IRA. The withdrawal should meet the following criteria:

• Made when you’re age 59½ or older
• Taken because you have a permanent disability
• Made by your beneficiary or estate after you pass away
• Used to buy, build, or rebuild a home that meets the first-time homebuyer exception

Non-qualified distributions are any withdrawals that don’t meet these guidelines. For these withdrawals, you’ll owe taxes at your ordinary income tax rate (remember, it just applies to earnings) and a 10% penalty.

Exceptions

There are still certain exceptions that apply. You can get out of the penalty (but not the tax) if you take the distribution for the following reasons:

• A series of substantially equal distributions
• Unreimbursed medical expenses that exceed 10% of your adjusted gross income (AGI)
• Medical insurance premiums after losing your job
• An IRS levy
• Qualified reservist distributions
• Qualified higher education expenses
  

Advantages and Disadvantages of Early Roth IRA Withdrawals

Taking out money from a Roth IRA (or any other retirement account, for that matter) before you have to isn't recommended. But you may come across times when it may be necessary. Let's take a look at the pros and cons of making early withdrawals from a Roth IRA.

Advantages

The most common benefit to making an early withdrawal from your Roth IRA lies in the type of contribution made. Roth IRA contributions are made using after-tax dollars, which means you've already been taxed. As such, you can pull out the contribution amount on a tax- and penalty-free basis. This doesn't apply to earnings, as we explain below.

There are certain situations where you may make early Roth IRA withdrawals without being penalized. As noted above, you don't incur penalties or taxes if you can prove that you are using the funds to pay for qualified medical or education expenses. A full list of exceptions are noted on the IRS website.

If all else fails and you have no other option, you can count on your Roth IRA as a last resort. But remember, you should only take this route if you absolutely must and have exhausted all other avenues.

Disadvantages

Not all of the money in your Roth IRA is penalty- or tax-free. Any earnings from your contributions that are withdrawn incur penalties unless they pass the five-year holding rule. Earnings only become penalty- and tax-free five years after you first contribute to any Roth IRA you have.

Another drawback to making an early Roth IRA withdrawal is that the IRS only allows you to withdraw and deposit the money back within 60 days. This means you're out of luck if you plan to use the money and plan to put it back after day 61.

The most obvious disadvantage is that you end up losing any money you would earn. Retirement accounts work on the principle of compounding interest, which means that the interest you earn also earns interest. If you withdraw money from your Roth IRA account early, you will miss out on any additional interest or dividends.

Borrowing from a Roth IRA

While you can’t borrow from a Roth IRA the same way you would from a 401(k), you can temporarily borrow funds as long as you return them to the same Roth IRA or a traditional IRA within 60 days. This is known as a rollover. There are very stringent requirements, including only one Roth rollover in a year, so work with your financial institution to make sure that your short-term loan isn’t treated as a non-qualified distribution.

Special COVID-19 benefits under the Coronavirus Aid, Relief, and Economic Security (CARES) Act—which applied only to the 2020 tax year—allowed account holders to borrow up to $100,000 from their IRAs and repay them within three years without a penalty.

Tax Implications

There is yet another loophole for earnings on Roth contributions. If you contribute and withdraw within the same tax year, then the contribution is treated as if it was never made.

For example, if you contribute $5,000 in the current year and those funds generate $500 in earnings, you can withdraw the full $5,500 penalty-free, as long as the distribution is taken before your tax filing due date. However, you would have to report those earnings as investment income.

Traditional to Roth IRA Conversions

Investors have the option to convert their traditional IRA to a Roth IRA. There are many benefits to converting, such as no required minimum distributions (RMDs) within the account holder’s lifetime.

The benefit of converting also depends on your tax bracket. If you decide to go through with it, you will have to pay taxes on the amount that you convert. If you expect to be in a lower tax bracket in the future when you withdraw the funds, then it might not make sense to convert now.

If you are under age 59½, and you use your traditional IRA funds to pay for the taxes when you do convert, you will incur a 10% penalty. Notably, a conversion itself is not a withdrawal, so there are no withdrawal penalties associated with a conversion.

The Bottom Line

If you have a Roth IRA, you can take out your contributions (but not earnings) at any time without paying taxes and penalties. Otherwise, if you remove money early from either a traditional or Roth IRA, you can expect to pay a 10% penalty plus taxes on the income (unless you qualify for an exception).

The decision to take an early withdrawal should never be taken lightly. You could miss out on years of potential growth and earnings, which could have a detrimental effect on your nest egg. But if you must access your funds before retirement, then many of the best brokers for IRAs have further information on how to avoid these penalties.