How to Avoid IRA Early Withdrawal Penalties
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How to Avoid IRA Early Withdrawal Penalties

By The Human Interest Team -

Individual Retirement Accounts (IRAs) allow individuals to save and invest funds for their retirement. These accounts offer significant tax savings and investment advantages. But they also have strict rules governing contributions and withdrawals. These include potential penalties for failing to make withdrawals correctly.

IRA Withdrawal Penalty: Overview

IRAs have withdrawal rules that determine when individuals may — or are required to — withdraw funds from their accounts. If you fail to follow these rules, you will receive an IRA withdrawal penalty, or a punitive fee, from the IRS. Two of the most important rules that govern IRA withdrawals are:

  1. If you are 59 1/2 or younger, you will receive a 10% early distribution penalty on all withdrawals except under certain circumstances.
  2. If you are 70 1/2 or older, you may incur a Required Minimum Distribution (RMD) penalty for not withdrawing a certain minimum. This penalty is 50% of the required withdrawal amount.

Statistics on IRA Withdrawals

Millions of Americans contribute to or rely on an IRA, so it’s important for both young and old to understand the rules governing IRA withdrawals. In fact, the IRS reported that just over 13 million people contributed to an IRA in 2015, the latest year with available data. Those contributions were worth an aggregate of $64 billion. 

At the same time, nearly 19 million people made an aggregate $295 billion in withdrawals. As older Americans continue to retire and age, they need to understand the importance of taking RMDs and avoiding the penalties of missed RMD withdrawals. Younger Americans also need to remember the penalty for early withdrawals.

Different Types of IRAs

IRAs are tax-advantaged retirement accounts that individuals can contribute to and use to make investments. These investments grow, and owners can withdraw the funds when they reach retirement age. There are four types of IRAs.

  1. Traditional IRA: Individuals can make pre-tax contributions. Pre-tax dollars can be contributed and grow tax-free. Owners will pay taxes when they make withdrawals at a later date.
  2. Roth IRA: Individuals can make post-tax contributions to a Roth IRA. With this type of account, you pay taxes up-front on the contributions you make and can then withdraw the funds later without having to pay taxes.
  3. SIMPLE IRA: Employers can sponsor retirement plans that include SIMPLE IRA accounts. Individual employees can make pre-tax contributions and pay taxes the year they withdraw any funds.
  4. SEP IRA: Employers sponsor and make contributions to SEP IRAs. Individual account owners cannot make contributions to these IRAs, only their employers, and the account owners pay taxes when they withdraw funds.

Details on IRAs

Each type of IRA follows specific rules, but they share some common rules. One of the most important rules governs RMDs, or required minimum distributions, that older account owners must make. These rules state that account owners must begin making withdrawals once they reach a certain age. If they fail to make RMDs once they reach 70 1/2, they will receive a penalty approximately 50% the amount of the required withdrawal amount. 

Also, individuals may only make contributions of up to $6,000 in 2019 ($6,500 in 2020), unless they are 50 or older. Older individuals may contribute up to $6,500 in 2019 ($7,000 in 2020). This contribution cap is for individual contributions across both traditional and Roth IRAs. The IRA-specific rules are as follows:

Traditional IRAs

IRA withdrawals will be taxed as ordinary income during the year in which the individual made the withdrawal. If you are younger than 59 1/2 when you withdraw traditional IRA funds, you will pay an additional 10% penalty on the withdrawn amounts.

Roth IRAs

IRA withdrawals are not taxed because you paid taxes when you made the contributions. You can withdraw contributed funds from a Roth IRA at any time provided the funds have been in the account for at least five years. However, you cannot withdraw earnings. Failing to follow these rules will also result in a 10% penalty on withdrawals.

 SIMPLE IRAs

Employees can contribute up to $13,000. Your employer may make contributions, but they are not required to do so. Both of the rules regarding early withdrawals and RMDs apply to SIMPLE IRAs.

SEP IRAs

Self-employed individuals or small business owners usually set up SEP IRAs. The contributions to these accounts are deductible and pre-tax. Employers can contribute up to 25% of their earnings or $56,000, whichever amount is less. SEP IRA owners must also follow the rules regarding early withdrawals and RMDs or face penalties.

Types of IRA Distributions

An early withdrawal from an IRA, or a withdrawal before you reach the age of 59 1/2, will receive a 10% penalty. However, some exceptions do apply. Also, employees that make withdrawals from a SIMPLE IRA within the first two years will receive a 25% penalty. 

RMDs are required for traditional, SIMPLE, and SEP IRAs. You must begin making required minimum distributions on April 1 of the year following when you turned 70 1/2. Each RMD is 4% of the total balance of that year. Failure to do so results in a penalty 50% the amount of the missed RMD, or 2% of the account value.

However, the IRA withdrawal rules allow for withdrawals or distributions when an individual has a heavy and immediate financial need as defined by the IRS.

How Much Will the Early Distribution Penalty Be?

The early distribution penalty fee is 10%. The exception to this blanket rule is withdrawals taken from a SIMPLE IRA within its first two years. In those circumstances, the penalty rises to 25%.

Exceptions to Early Distribution Penalties

You should try to avoid making early withdrawals from your IRA under most circumstances. However, the IRS allows for several exceptions to the early withdrawal penalty in the event of hardship and other factors. These exceptions include:

Knowing the rules that govern IRA withdrawals can help you avoid penalties. Learn more about the different types of tax-advantaged retirement plans available and how Human Interest can help your company manage employer-sponsored retirement accounts.

The Human Interest Team The Human Interest Team

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