Cashing Out Early

If IRA tax breaks are the carrots Congress uses to encourage you to save for retirement, penalties for early withdrawal are the sticks that make sure you keep at it.

Not to worry, IRAs contain a number of penalty-free escape hatches. Here are the early-out rules to consider for traditional IRAs and Roth IRAs.

Traditional IRAs

For the most part, if you dip into your account before you're 59½, you may be hit with a 10% penalty for premature distribution.

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We say you may be hit with a penalty because there's an ever-growing list of exceptions to the penalty. For example, it's waived if:

• You become permanently disabled.
  
• You use the IRA money to pay medical bills that exceed 10% of your adjusted gross income.
  
• You use the money to pay for medical insurance during an extensive period of unemployment.
  
• You use up to $10,000 to help pay for or build a first home for yourself, your spouse, your kids, your grandchildren or even your parents. That $10,000 is a lifetime limit, not an annual one.
  
• You use the money to pay higher-education expenses for yourself, your spouse, a child or grandchild. Qualified expenses include tuition, fees, and room and board for postsecondary education, including graduate work.
  
• You take the money in equal annual amounts, designed to exhaust the account during the course of your life expectancy (as estimated by the IRS). You can increase this amount by adding reasonable future IRA investment earnings when figuring the size of the payouts.You can begin this kind of early-withdrawal plan whenever you want, but to dodge the 10% penalty, you must stick with it for the longer of five consecutive years, or until you turn 59½.

Warning!Even though qualifying withdrawals escape the 10% penalty, they would be taxed in your top bracket (except to the extent it was attributable to nondeductible contributions).

Roth IRAs

Roth IRA withdrawals are hit with a 10% penalty if you cash in before age 59½ and they lose their tax-free status. However, there are ways to get money out of a Roth tax- and penalty-free.

You can reclaim contributions at any time and at any age, without fear. Only earnings are subject to penalties. And Congress said that the first money coming out of Roth IRAs will be considered contributions.

But, money that is converted to a Roth must generally stay in the account long enough to meet the five-year test -- that is, for four calendar years after the year of the conversion -- to avoid the 10% penalty.

Example: In 2010, a 30-year-old converted $20,000 to a Roth IRA. The five-year test would be met at the end of 2014, so at age 34 the investor could withdraw the $20,000 tax- and penalty-free.

Roth earnings

So, how are Roth earnings taxed? Earnings are tax-free if you pass the five-year test and meet other tests:

• You are 59½ or older at the time of withdrawal.
• The money is used for a first-time home purchase (up to the $10,000 limit).
• The money is distributed after you become disabled.
• The money is distributed to your heirs after your death. If you die before meeting the five-year test, heirs would have to wait until the year you would have passed that test to withdraw earnings tax-free.
• In other instances, failure to meet the five-year test guarantees that your earnings will be taxable, regardless of your age, even if the earnings escape the 10% early-withdrawal penalty. For example, whether or not the five-year test is met, withdrawals at any age to pay qualifying college costs dodge the 10% penalty. But the earnings will be taxed -- unless you're older than 59½ and meet the five-year test, in which case earnings can be withdrawn tax- and penalty-free for any purpose.