The traditional Individual Retirement Arrangement is an investment plan that allows you to save toward retirement using pre-tax dollars. The Internal Revenue Service presumes that the account holder will be older than age 59 1/2 when taking the first distribution. Because they're intended to help people save for the future, the penalties for taking an early lump sum distribution are stiff, but taking a lump sum at anytime will have significant consequences.
Although you may take a distribution prior to age 59 1/2, the federal government imposes a 10 percent tax penalty on your distribution on top of ordinary income tax. A lump sum distribution will be included in your income for the year in which it was made and will often push you into a higher income tax bracket for that year. Lump sum distributions prior to 59 1/2 could be extremely burdensome.
The federal government forces beneficiaries of inherited traditional IRAs to take minimum required annual distributions regardless of age. The distributions are not subject to the 10 percent penalty tax but are taxed as ordinary income. Beneficiaries are allowed to take their distributions as a lump sum, but, again, the full amount will be included as income in the tax year it is distributed. The minimum required distribution is based on the life expectancy of the beneficiary, but there is no restriction on beneficiaries taking a larger distribution if they want access to more of the money sooner without the significant tax liability of a lump sum.
Missing Potential Returns
Even if you wait until after age 59 1/2 or until you retire and are in a lower tax bracket to take a lump sum IRA distribution, you can miss out on significant returns. While you are required to begin taking required minimum distributions by the year in which you turn age 70 1/2, all funds remaining in your IRA continue to earn investment income tax deferred. If you were to take a lump sum and invest all or part of it elsewhere, you would not only pay income on the distribution but future earnings on your investment would be subject to income or capital gains taxes.
Aside from an heir who is forced to take a distribution, the IRS does eliminate the 10 percent penalty on early distributions in some cases. For example, if you become disabled or need the money to pay for medical care -- including health insurance if you're unemployed -- that's greater than 7.5 percent of your adjusted gross income, the penalty doesn't apply. If you need the money to pay for college for yourself, your spouse or your children or grandchildren, it's penalty-free. Account holders can use up to $10,000 for a first-time home purchase as well. Finally, excess contributions that you made that are beyond the tax deduction limit aren't subject to the penalty. However, keep in mind that all of these distributions beyond your own after-tax contributions are taxed as regular income.
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