Early Withdraw Penalty on a IRA

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daveswoodhauler

daveswoodhauler

Minister of Fire
May 20, 2008
1,847
Massachusetts
Ok, not wood related but I figured someone here has either gone through this or at least looked into it.

Situation is that we are probably going to cash in a small IRA early, as with my income not increasing with the economy, and three kids eating more and more. (Please no lectures about having three kids and not being able to afford....even though I understand its a just point)

So after reading online, I am still confused with the 10% early withdrawal pentaly...is it truly a penalty? or is it just an extra withholding of another 10%??


I know that there are dangers of the early withdrawal, but we are only one year away from my wife going back to work and having a second income again after 10 years.....we made it a long 9 years, but I think this upcoming year is going to bust us over the edge.

The main reason I ask about an additioanl withdrawal or an actual penalty is that I had some capital gains from sale of stock this year, and where we normally get back about $2000 in federal, we are proobably just going to break even due to the taxes on the capital gains. I was thinking that the extra withholding may work in our advantage, but I am thinking that this is not the case and its a true 10% penalty and not just extra withholding.

Ps, In addition, th IRA is down 17% of the original cost basis, so was hoping that this would offset some of the capital gains of the stock sale
 
The early withdrawal penalty of 10% is a Federal Penalty and this is in addition to any income tax due.

In addition to the above there may also be charges due to breaking the terms of the instrument(s) of the IRA that are "cashed in".
 
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An IRA doesn't operate like a stock sale. You are taxed on the money that comes out as ordinary income for a traditional IRA plus a 10% penalty on the distribution. If you take $5,000 out of traditional, you will pay on your income tax return a $500 penalty plus ordinary income tax rates on the $5,000. This is assuming we're talking about an IRA that you made pre-tax contributions into and you are under 59 1/2 or don't meet some other exceptions.
 
I have seen alot of these done in this economy. One more reason to invest in guns and gold and bury them in your back yard if you have to. Everything else is iffy these days.
 
firecracker_77 said:
An IRA doesn't operate like a stock sale. You are taxed on the money that comes out as ordinary income for a traditional IRA plus a 10% penalty on the distribution. If you take $5,000 out of traditional, you will pay on your income tax return a $500 penalty plus ordinary income tax rates on the $5,000. This is assuming we're talking about an IRA that you made pre-tax contributions into and you are under 59 1/2 or don't meet some other exceptions.
Click to expand...

Thanks for the info both of you. So what you are saying is that one cannot deduct a capital loss on the sale of a stock/mutual fund. I.e. Bought Mutual fund in an IRAat say $5500 and its now worth $4200 ($1300 loss) I figured that the say $4200 would be considered income, but I could still deduct the loss of the mutual und against other gains I have had. If not, this really sucks.
 
Yes it can suck big time. You don't normally pay any taxes on the money you "invest" in your IRA so whatever comes out is taxable income. It is possible for a certain amount to have had taxes paid on it, it depends upon how you chose to report it at tax time.

You can also take a good hammering on cashing in early if your IRA is held in long term CDs or there were terms in the investment instrument you bought dealing with pre term surrender. This is in addition to what the tax man is going to do.
 
It sounds like this will be expensive both in the short and long terms. Is there any way to borrow the money, interest rates are quite low. I keep getting offers from my credit card company that is basically a check that only costs 1% of the amount you make it for and 0% interest for a year. I may use it for a major purchase I have planned, but you must be disciplined and pay it off in the first year.
 
Personally I would not use the credit card co. They have a bad habit of raising interest rates at the mere hint of a breeze and considering that they prefer you to be paying close to 30% interest, it is best to stay away from them. Most of the time that rate is just a come on to hook you. Better to find a more traditional source, if possible, and avoid there excuses for raising the rate ( like a payment that they credit to your account a day after the cut off, poof, late charges, instant rate increase.) Lately they have been dancing the payment addresses around if paying by mail, so if you do not get it out right away you might get caught in this scam. Latest one is batch processing only few times a month, yep, that means if you miss your assigned batch you get nailed as late again. (AT&T has been running this scam for years). You are considered a bad customer if you consistently pay your bill on time or pay it off every month so there are no interest charges ( they hate me).
 
Hmmm.. i wonder if you could convert it to a Roth , pay the taxes on conversion and then withdraw. There is no penalty on roth withdrawalias long as you only take out contributions, not earnings.

I'm not sure how contributions are defined for conversions and i think there is some minimum time it has to sit, so may not work. Tax attorney question probably.
 
Ahhh, internet financial advice! I can't speak for the IRA, but would just point out, if you're continually getting $2000 back in federal taxes, you might consider adjusting the amount deducted from your pay. You might as well have the money vs the government. An extra $166/month would buy a decent amount of food!
 
This is getting past the initial question.

Conversion to a Roth needs to be carefully looked at as the taxable conversion amount gets added to your current incomes and that can drastically impact your current taxes due. IRAs are a tax deferment, you are deferring the tax obligation until you are in a lower taxable income situation thus reducing your current tax liability and hopefully your total lifetime tax liability.

This is a mine field that needs a map to navigate without getting your hind quarters handed to yourself.

ETA: We use a garden to offset a good portion of our food bill and do a lot of other things to keep our costs down. We have the time so it works out fine for us.
 
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SmokeyTheBear said:
This is a mine field that needs a map to navigate without getting your hind quarters handed to yourself.
Click to expand...

My thoughts exactly. I only know enough about this to know I don't know enough. Get yourself a financial planner. There are free resources available, if you cannot afford one. That said, be leary of putting all of your assets with one planner (ask Bernie M's friends).

Some interesting ideas have been thrown out here, some worth consideration, but most don't help you with the short term problem. Liquidating assets, or withdrawing on retirement are short term solutions, but perhaps that's what you need right now... if you're sure the outlook for next year is truly better.
 
Next time, use the roth. I'm a big roth fan.
 
My concern with the ROTH ira is that the government will just come up with another way to tax you, that's why I haven't converted my IRAs to ROTHS
 
They are going to tax income, the trick is to have that taxable income only when your tax would be as close to zero as possible. That usually happens when you pick up the extra exemptions when you become an old fuddy duddy and start collecting Soc. Sec. of which only half in general is actually income to you.
 
Have you considered taking out a loan against the IRA?
 
I used to work for a mutual fund transfer agent. For those who don't know, mutual funds hire TAs to handle all the customer service and account management(most people never actually interact with MF companies directly). Anyway point is I dealt with this stuff all the time. I really can't add much more than to say SmokeyTheBear's advice is correct.

I'm assuming you have a standard mutual fund account, if so, call their customer service. They can't give you investment or tax planning advice but they should be knowledgeable enough in explain the tax implications.

Are these funds no-load(ie no sales charges). If they're B/C share class you might have to pay a sales change when you redeem if you haven't held them long enough. If it's A shares you've already paid a fee when you bought them so redeeming early won't add any more pain.

If it's at all possible keep the IRA, to be effective as a retirement plan they need penalties to prevent early withdrawal. I know sometimes you really need cash but retirement should be the last place you go unless you have no other choice. Personally I'd give up almost anything before tapping my retirement.
 
Thanks for all the thoughts and advise folks. We don't carry any credit card debt (pay off balance each month) so I am not going to go that route. (Same would go for tapping into my HEL of credit) This "should" (I hope) be a short term situation for the next year, as my youngest is entering into his last year of preschool, then next year my wife can go back to work at least part time to supplement the income. (20 hours / week or so)

As others have said with respect to an income tax refund, we normally see about $2000 back per year, bu this year I changed the witholding to make it closer to $500 or so. The problem arose with two items....first, my company (public) sold to a larger corporation, so all the stock I had I received a cash payment for. (Large capital gains.....most of that is gone as we used it to finish the kids playroom). Second is that my wife usually makes about $3000 year doing contract work, and right now she has earned about double that with no taxes being withheld....so I am most likely looking at paying in for taxes next year vs receiving a refund.

We have a garden, have basic cable ($18/month), use the clothes line, cfls, etc...so we have really done ust about everything we can to cut down on the costs....its really just a matter of inflation being greating then pay increases. In addition, next year my youngest will start full day kindergarden, so that will negate a $266/month bill that we have for preschool right now.

I can take a loan from my 401K with no problem, but I don't want another monthly bill as that is the main issue. I was pondering cashing in $5000-$7000 of an IRA for a short term solution until next year rolls around....I really think its just going to be an issue for 2012-2013.

Again, thanks for all the help and advise....many of the above I have looked at and pondered...just don't want to go a loan route.
 
You sure have my sympathy, it is very expensive to live now a days. My wife and I make what I consider a decent living and money is still farely tight.....I don't know what people with lower incomes and a couple of kids do._g
 
Yeah sometimes its a matter of the lesser evil. 401k loan would at least not have the tax penalty that the early ira distribution would. Also you'd be paying the interest to yourself rather than a penalty to uncle sam. Problem with 401k loans is if you leave your employer, for whatever reason, you have to pay it all back. In this economy that scares me, but I have no idea how stable your employment is.

Either way you have to do what you feel is best. With a 2yo and a baby on the way, I can certainly relate. Good luck regardless of your choice!
 
Someone with a whole life, life insurance policy also likely has a loan availability that may be at a decent rate or even not have to be paid back. One needs to pay close attention to those as well, but they can be a viable option.
 
Are you still contributing to your 401k? Have you considered stopping your contributions for now, taking out the loan from your 401k or IRA and using what you would have contributed to your 401k to pay the loan back? If it's close to a breakeven for you monthly it might be a great solution.

Ditch the cable even if it's not to save the money. Especially if you have young kids (I do too). Us younger families need to change this country. Step one - step away from the TV. My opinion only of course!
 
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