IRAs are a great way to save for retirement, but you have to be willing to leave your money in the IRA throughout most of your career. If you try to tap into your IRA before you reach the age of 59 1/2, you'll typically have to pay an early withdrawal penalty. Yet certain investments that you make within an IRA can also charge early withdrawal penalties. Understanding the difference is important in deciding what you can and can't deduct for tax purposes.
The 10% penalty for early IRA withdrawals
If you take money out of your IRA before reaching 59 1/2, then you'll usually have to pay an additional 10% penalty to the IRS unless you qualify for an exception to the penalty rules. This penalty takes the form of an additional tax, and so it's not treated the same way as an early withdrawal penalty on a bank certificate of deposit. Specifically, you're not allowed to deduct the 10% penalty on Line 30 of your Form 1040 as a penalty on early withdrawal of savings, because technically, the deduction is only available on money that was withheld from what would otherwise have been taxable interest.
In addition, you're not allowed to deduct the 10% penalty from the amount you include in taxable income as a result of making the IRA withdrawal. The penalty is treated as additional tax, and it's meant to be a disincentive to taking money out of your retirement account before reaching age 59 1/2.
Early CD withdrawals and penalties
By contrast, what you can deduct on Form 1040 is an early withdrawal penalty you pay on a bank savings account. However, again, the rules for taxable accounts are different than for CDs held in an IRA.
If you hold a CD within an IRA and cash it in early, the key issue is whether you leave the proceeds in an IRA. If you do, then there's no taxable event, but you also won't be able to deduct the lost interest. If you take the money out of the IRA entirely, then the amount that you'll receive will be reduced by the amount you forfeited from cashing in the CD early. That means that your reportable taxable income will be reduced by the CD penalty amount. Effectively, that's equivalent to getting a deduction for the forfeited amount, because you won't have to pay tax on it.
The most important takeaway from the rules on penalties and IRAs is that the 10% tax on early IRA distributions is designed to keep you from taking early withdrawals from your account. The best course in dealing with your IRAs is to commit to keeping your retirement money untouched if at all possible to avoid the whole question of whether penalties apply at all.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected]. Thanks -- and Fool on!