Rules & Restrictions

Penalty-Free Traditional IRA Distributions

The government wants IRA money to be used for retirement. A 10% penalty applies to distributions that are taken for non-approved reasons to discourage frivolous spending. This penalty is in addition to any taxes that may apply.

Properly executed distributions from any traditional IRA are taxed as ordinary income. Recall that contributions to traditional IRAs are usually with tax-deductible dollars. Distributions, however are added to income and taxed at ordinary rates. An individual may complicate the tax situation somewhat by contributing after-tax dollars to an IRA, but not by much. After-tax contributions are not taxed again upon withdrawal.

To the contrary, properly executed Roth IRA distributions are tax free, except if a distribution occurs within 5 years of the first contribution and another qualifying factor is not present (to be discussed later).

• IRS Tax Forms: There are two tax forms that are generally used by individuals in conjunction with IRAs:
  • Form 8606: Taxpayer tracks after-tax contributions to an IRA to avoid double taxation of distributions.
  • Form 5329: Taxpayer uses this form to avoid the additional 10% penalty on premature distributions that are used for exceptions, such as first-time home buyer, higher education, or medical expenses (explained later).

CESA and HSA withdrawals are explained in a separate section

Penalty Free Distributions at 59 ½

There is a 10% penalty (addition to any taxes) that is imposed whenever traditional owners take distributions from their traditional IRA before the year they reach 59 ½. The penalty for premature distributions may be avoided for the conditions below:

• Death distributions to a beneficiary or estate.
• Owner is not yet 59 ½ but is disabled.
• Distributions comply with Substantially Equal Periodic Payments (see a tax advisor).
• IRS levy (get a new tax advisor).
• First-time home buyer qualifies for $10,000 penalty-free withdrawal.
• Certain health insurance premiums for qualified unemployed individuals.
• Medical expenses in excess of 7.5% of adjusted gross income (see a tax advisor).
• Qualified higher education expenses (see a tax advisor).

Tax form 5329 is filed by the taxpayer to claim one of the reasons above to avoid the 10% penalty.

Federal Tax Withholding - Don't Confuse with Penalty

Permitted Roth Distributions

This will be discussed in more detail later. Suffice it to say that you should not confuse this optional tax withholding with a penalty. Traditional IRAs distributions are subject to a 10% income tax withholding unless the IRA owner signs a form W-4P instructing the bank to not withhold taxes. More will be said about this later when we more fully discuss distributions.

The withholding rules do not apply to Roth IRA distributions that are generally tax-free anyway.