Most people open individual retirement accounts to save for retirement. However, liquidating your IRA early sometimes might be in your best interest. Knowing the rules as to when you can liquidate, and the taxes and penalties that will result, can help you time your liquidation to your advantage and possibly avoid some of the penalties.
The Internal Revenue Service does not make you jump through any hoops or meet special requirements just to take money out of your IRA -- you can do so at any time. But the IRS imposes a 10 percent early-withdrawal penalty if your liquidation is not considered a qualified withdrawal. In most cases, to avoid the penalty, traditional IRAs require you to be at least 59 1/2 when you liquidate. Roth IRAs have the same requirement, and your Roth must be at least five years old when you liquidate it.
Liquidation Penalty Application
If you liquidate your IRA before meeting the IRS's requirements for qualified distributions, you have to pay a 10 percent penalty on the taxable portion of the liquidation. The distinction between taxable and nontaxable liquidations is important for Roth IRA distributions, because your contributions in a Roth IRA always come out as a nontaxable distribution. Your earnings from a Roth IRA, and your deductible contributions and earnings from a traditional IRA, are all taxable.
For example, if you contribute $14,000 to a Roth IRA and it grows to $25,000 by the time you liquidate it, the penalty applies only to the $11,000 of earnings, so the penalty would be $1,100.
Hardships May Eliminate Penalty
If you meet any of the hardship conditions as defined in IRS Publication 590, you can reduce or eliminate the amount of your distribution on which you owe the early-withdrawal penalty. For example, if you are paying for your child's tuition or using up to $10,000 for a first house, that money comes out penalty-free. You also avoid the penalty if you pay for medical expenses that are greater than 7.5 percent of your adjusted gross income, or medical insurance while you are on unemployment.
No Income Tax Waiver
The income taxes imposed on distributions are not waived for financial hardship. For example, even if you use the entire amount of a traditional IRA liquidation to pay for your child's college, the IRS still requires you to include that amount in your taxable income on your tax return.
If you take a qualified Roth IRA distribution, you do not have to pay any taxes on the liquidation, because qualified Roth distributions come out tax-free.