Taxation When Closing an IRA

by Cindy Quarters

An individual retirement account (IRA), is a type of savings account intended to help the account owner accumulate money for retirement. Since the purpose of the account is retirement savings, there are typically both taxes and penalties involved when an account is closed prematurely. How much tax is due depends on a number of different factors including the type of IRA, the age of the account holder, the circumstances for closing the account and what other income the account holder has.

Traditional IRAs

When a traditional IRA is set up, it is funded with tax-deferred money. Instead, taxes are due when the money is taken out of the account. Ideally the income is received after the account owner has retired and she is in a lower tax bracket than she was when she was working. At the time she receives distribution of her funds, she will owe taxes on both the amount of the original contributions and any earnings from the account. Normally, distribution is spread out over many years, so the taxes remain relatively low. If the funds are all received at once because the account is closed, the taxes are all due at once as well.

Roth IRA

A Roth IRA is different from a traditional IRA in that the money contributed to the account is after-tax dollars, meaning all funds placed in a Roth IRA have already had taxes paid on them. When getting funds from a Roth IRA, no taxes are due on the contributions, since taxes were paid when the money was put into the account. A special provision of Roth IRAs says that no taxes are due on the account earnings, either, so a Roth IRA that is closed will not owe any taxes, provided there are no penalties involved.

Penalties

Retirement accounts are intended to be long-term accounts that are not used until the account owner reaches the age of at least 59 1/2. To discourage people from closing their accounts early, a 10 percent penalty is assessed on any account where the owner is not eligible for distribution of the funds. Generally, eligibility means the person receiving the funds is at least 59 1/2 years old, disabled or a beneficiary of the original account owner. There are other conditions that may also allow an IRA to be closed and the funds to be distributed without penalties.

Withholding

When money is taken from an IRA, the trustee that was holding the funds is required to withhold funds for taxes. For most IRAs, tax withholding is 20 percent, though this amount is not required for Roth IRAs. In addition, unless it is a qualified distribution, meaning the person is eligible to receive the money without penalties, an additional 10 percent is withheld from all IRA funds when they are distributed. Depending on the person’s individual situation, these funds may or may not be enough to cover the actual tax liability, since the regular IRA money is counted as income for the year.