Unlike a 401k plan, which only allows early withdrawals in the event of a hardship, you can close your IRA for a hardship or any other reason, but you'll likely have to pay extra at tax time. Understanding the tax effects of closing your IRA for a hardship helps you make a more informed decision about whether to close your IRA or find another source of funds, such as a loan. The Internal Revenue Service rules treat all disbursements of money from an IRA the same whether the disbursement is just a small portion of account or if the disbursement closes the account completely.
Only certain circumstances allow you to qualify for an exemption from the IRA early withdrawal penalty if you close your IRA for a hardship before age 59 1/2. A permanent disability or money taken out to pay medical expenses exceeding 7.5 percent of your adjusted gross income waives the penalty. For example, if you have an AGI of $50,000, any medical bills over $4,125 would result in a waiver of the early withdrawal penalty. You also avoid the penalty of you take out money for post-secondary education. Hardships not specified by that IRA do not avoid the penalty. For example, if you lose your job and close your IRA to pay for rent and food, you still get charged the early withdrawal penalty.
Early Withdrawal Penalty
If you close your IRA for a hardship that is not classified as an exemption from the early withdrawal penalty, you must pay a 10 percent early withdrawal tax penalty. If your exception only covers part of your withdrawal, you have to pay the penalty on the uncovered portion. For example, if you cash out $15,000 from your IRA, your AGI equals $55,000 and your medical bills total $15,000, you would avoid the penalty on $10,875 of your distribution. You would, however, owe the penalty on the first $4,125.
On top of any early withdrawal penalty, or even if you qualify for an exception from the penalty, you still have to pay income taxes on the distribution when you close your IRA for a hardship. The amount of the distribution counts as unearned income, which means you do not have to pay FICA or self-employment taxes on it, but you do have to include it in your taxable income. The federal government taxes the money at your marginal tax rate.
Tax Filing for Closing an IRA Due to Hardship
When you close your IRA for a hardship, you have addition income tax form to file. To calculate your penalty or report your qualifying reason for waiving the penalty, file Form 5329. On the form, report the code for your qualifying exception, if any. For example, if you closed your IRA because you suffered a permanent disability, enter the code "03" next to line 2. Attach Form 5329 to your tax return. For your tax return, use Form 1040 to report both the amount of the distribution and the amount of your penalty. The IRS does not mandate that you submit evidence, such as receipts, of your financial hardship with your tax return if it qualifies for an exception. You should, however, keep copies of any documentation to prove your hardship in the event of an IRS audit.
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