The IRA Cash Out Penalty and How to Avoid It
Taking an early IRA distribution has tax implications. Understand the rules for accessing your funds and the process for qualifying for a penalty exception.
An Individual Retirement Arrangement, or IRA, is a savings tool designed to provide funds for retirement. Taking money from these accounts is known as a distribution. When a distribution occurs before a specific retirement age, it is considered an early distribution, often referred to as a “cash out.” This action can trigger tax implications that individuals should understand before accessing their funds.
The 10% Additional Tax on Early Distributions
If you withdraw funds from your IRA before reaching age 59½, the withdrawal is considered an early distribution and is subject to a 10% additional tax. This is an additional tax on top of any regular income tax you owe on the withdrawn amount. The tax applies to the portion of the distribution that must be included in your gross income for the year.
The taxable portion depends on the type of IRA. For a traditional IRA, contributions are made with pre-tax dollars, so the entire distribution is included in your gross income and is subject to the 10% additional tax. For example, a $20,000 early withdrawal could result in a $2,000 additional tax, plus the ordinary income tax due.
For a Roth IRA, since contributions are made with after-tax money, you can withdraw your direct contributions at any time without tax or penalty. The 10% additional tax and income tax only apply to the earnings portion of an early distribution. A special rule applies to SIMPLE IRAs; if a withdrawal occurs within the first two years of participation, the additional tax increases to 25%.
Qualifying for an Exception to the Penalty
The Internal Revenue Code provides several exceptions that allow you to take an early distribution without the 10% additional tax, per IRC Section 72. For example, if you become totally and permanently disabled, you can take distributions from your IRA without penalty. Upon the death of the IRA owner, the beneficiary who inherits the IRA can also take distributions without this additional tax.
One of the most common exceptions is for a first-time home purchase. An individual can withdraw up to a lifetime limit of $10,000 penalty-free to buy, build, or rebuild a first home. To qualify as a first-time homebuyer, you or your spouse cannot have owned a principal residence during the two-year period ending on the date of acquisition. The funds must also be used for qualified acquisition costs within 120 days of receiving the distribution.
An exception also exists for qualified higher education expenses for yourself, your spouse, children, or grandchildren at an eligible educational institution. While there is no dollar limit, the distribution cannot exceed the amount of the qualified expenses. Unreimbursed medical expenses may also qualify for a penalty-free withdrawal for the amount that exceeds 7.5% of your adjusted gross income (AGI). If you are unemployed, you may take penalty-free distributions to pay for health insurance premiums.
Other circumstances that qualify for an exception include:
- Distributions made as a series of substantially equal periodic payments over your life expectancy (SEPP).
- Withdrawals by a qualified reservist called to active duty for at least 180 days.
- Withdrawals up to $5,000 for expenses related to a qualified birth or adoption.
- Withdrawals up to $10,000 for victims of domestic abuse.
How to Report Withdrawals and Claim Exceptions
When you take a distribution from your IRA, the financial institution issues Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. This form reports the distribution to you and the IRS, and Box 7 contains a code indicating the reason for the withdrawal. For example, a code ‘1’ signifies an early distribution with no known exception, while other codes might indicate a specific exception like death or disability.
To calculate the penalty or claim an exception, you must file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, with your annual Form 1040 tax return. This form is used to report why your distribution is exempt from the 10% additional tax.
If your Form 1099-R has a distribution code of ‘1’ in Box 7 but you qualify for an exception, you must file Form 5329. On this form, you will report the amount that qualifies for an exception and enter the corresponding exception code from the form’s instructions. For instance, the code for a first-time home purchase is ’09’, while the code for higher education expenses is ’08’.
After completing Form 5329, the result is either the amount of additional tax you owe or zero if an exception covers the entire distribution. Any tax owed is carried over to Schedule 2 of your Form 1040. You must attach the completed Form 5329 to your tax return to document your exception and avoid an automatic penalty assessment by the IRS.