IRAs are an excellent way for taxpayers to save for their retirement in a tax-advantaged manner, whether it be with pre-tax dollars in a traditional IRA (and taxable when withdrawn) or post-tax dollars in a Roth IRA (and non-taxable when withdrawn). During hard times or a need for cash flow, people may decide that one of the ways they can help cover this shortfall is through an early IRA distribution. This withdrawal, however, can have a major effect on taxes due at the end of the year.
As mentioned above, Traditional IRAs are typically funded with pre-tax money (meaning the taxpayer does not pay tax on the income now) and therefore will be taxable income when withdrawn on both the contributions (since tax was never paid on them) and any earnings. Roth IRAs are funded with post-tax money (meaning the taxpayer has already paid tax on the income used to fund the IRA) and therefore any qualified withdrawals are tax-free. All other things equal, over the long run, a Roth IRA and a Traditional IRA will provide the same amount of retirement income on a net tax basis, assuming similar tax brackets and post-tax returns on invested savings.
|Assume: 25%||current tax bracket|
|Traditional IRA||Roth IRA|
|Current Tax Savings||$1,375|
|IRA Balance||30 years @ 5%||$23,771||$23,771|
|Tax Savings||30 years @ 5%||$5,943||$0|
IRA withdrawals generally become qualified at age 59 ½, meaning that they are no longer subject to any early withdrawal penalties. (Note: there are certain exceptions to this rule which are beyond the scope of this article.)
Early Traditional IRA Distribution
An early Traditional IRA distribution is fully subject to income tax, similar to how a qualified distribution would be fully taxable. However, the early distribution is also subject to a 10% penalty on the full amount. This penalty is steep and has the potential to erode any tax deferral benefits you have received in the past.
Early Roth IRA Distributions
An early Roth IRA distribution is only subject to tax on the earnings of the Roth, not the initial contributions. This holds true for both income tax and the 10% penalty. The distributions are subject to ordering rules, which generally hold that Roth IRA distributions are made in the following order
- Regular contributions
- Conversion and rollover contributions
- Earnings on contributions
Any conversions on multiple IRA accounts can complicate this transaction as there are specific aggregation rules. This calculation should be examined on a case-by-case basis.
Early Withdrawal Example (5,500 at 5% per year for 20 years).
Hopefully, a taxpayer will never have to face a situation where they are forced to make an early unqualified distribution from their IRA. When making this decision, it is important to understand how this will affect the taxpayer’s tax due at year-end as so that they do not dig themselves into a further hole.
Edward McWilliams, CPA
Ed is a Partner in the firm’s tax and business advisory practice focusing on providing services to middle market private companies across different industries as well as to early stage startups. Ed has over a decade of experience providing tax and business consulting services to these companies of different sizes and across different industries, bringing a broad and diverse knowledge base and strategic solutions to the many complex issues that businesses face.