How to Calculate Early Withdrawal Penalties on a Retirement IRA

If you dip into your retirement money early, you can end up paying the price.

Oct 25, 2015 at 10:06PM

IRAs are special accounts designed to help people save for retirement. Yet many people find themselves in financial situations in which they have to consider dipping into their IRA money early. In those situations, it's important to know that there can be substantial early withdrawal penalties and other tax consequences. Let's look more closely at the IRA early withdrawal penalty rules, and the many exceptions that can help you avoid penalties in some circumstances.

The general rule on early withdrawals from IRAs
In general, IRAs are meant to be left untouched until you reach retirement age. The law that established IRAs set the age of 59-1/2 as the measuring point for regular versus early withdrawals. Once you reach age 59-1/2, you can take money out of an IRA penalty free. Before then, though, you'll generally owe a 10% penalty on the amount that you withdraw.

However, there are ways that you can tap IRAs without penalty even if you're not yet 59-1/2 or older. You'll still have to pay income tax on the amount withdrawn from a traditional IRA, but the additional 10% won't apply.

Ways to avoid the IRA early withdrawal penalty
The tax laws include a number of common situations in which you can make penalty-free withdrawals from IRAs regardless of your age. Money used to pay for college expenses for yourself or a close family member are exempt from penalties, as are withdrawals used to pay medical expenses to the extent that they exceed 7.5% of your adjusted gross income. Those who are unemployed can use IRA money to purchase health insurance at no penalty, and homebuyers can use up to $10,000 of IRA withdrawals toward a first-time home purchase. Finally, those who become disabled can take withdrawals from IRAs without penalty.

In addition to these specific situations, a more general rule allows IRA owners to take withdrawals in a series of what are known as substantially equal periodic payments. These payments, which are defined in Section 72(t) of the Internal Revenue Code, offer three different methods you can use to calculate how much you're allowed to withdraw on a penalty-free basis. The easiest method uses the same tables that older IRA owners can use to calculate their required minimum distributions at age 70-1/2 and later. This method typically allows you to take only a small portion of your total IRA funds -- roughly 2% to 3% for most people -- but it can be extremely useful if you decide to stop working before reaching age 59-1/2, and need a modest, but steady, stream of income.

Finally, some investments you can buy in IRAs charge early withdrawal penalties of their own. For instance, if you buy a bank CD in an IRA, you might have to pay several months' worth of interest in order to pull money out before its maturity date. That penalty goes to the bank, and is in addition to the 10% penalty for withdrawals that's imposed by the government.

Ideally, it's best to leave money in an IRA until you retire. Knowing the consequences can help you decide whether it's worth taking money early and having to pay the penalties involved.

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4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

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This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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