Liquidating your IRA before retirement usually costs you more in taxes and penalties that it is worth. However, sometimes you may not have any other source of funds. Knowing how your IRA liquidation affects your income taxes helps you figure out if liquidating your IRA is in your best interests.
Even if you completely empty your IRA, the same rules apply in determining whether you took a qualified distribution or not. For traditional IRAs, if you liquidate before age 59 1/2, the distribution is nonqualified. For Roth IRAs, if you liquidate before the account is five tax years old, or before you are 59 1/2, your distribution is nonqualfied. The IRS applies an early withdrawal penalty to the taxable portion of a nonqualified distribution.
Taxable Portion of an Early Liquidation
When you liquidate your IRA through nonqualified distributions, you have to figure the taxable portion of the distribution. With a traditional IRA, both deductible contributions and earnings are taxable so barring you having made nondeductible contributions, the entire distribution is taxable. If you made any nondeductible contributions to your traditional IRA, those come out tax-free when you liquidate your entire account. With a Roth IRA, your contributions come out tax-free, but the earnings are taxable. For example, if you liquidate a Roth IRA with $50,000 of contribution and $30,000 of earnings, $30,000 is taxable.
Income Taxes on IRA Liquidations
IRA liquidations are treated the same as regular distributions for calculating the amount of income taxes you owe on the distribution. When you file your taxes, you report the taxable portion of the distribution on your tax return and pay your marginal tax rate on the distribution. However, if your distribution pushes you into a higher tax bracket, the amount of your distribution in that higher bracket will be taxed at the higher rate.
Early Withdrawal Penalties on IRA Liquidations
The 10 percent early withdrawal penalty applies to any taxable portion of your nonqualified liquidation not covered by an early withdrawal exception. Your exception may cover only part of the liquidation. For example, if you have $4,000 in medical expenses exceeding 7.5 percent of your adjusted gross income but you have $9,000 in taxable distributions, the penalty would apply to $5,000. If your exception covers you entire distribution, such as if you are permanently disabled, you owe no early withdrawal penalty, but you still owe income taxes.
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