Can someone explain how IRA early withdrawal penalties are calculated?

January 24, 2013 9:44 AM

Everywhere mentions a 10% penalty, but nobody says whether this is pre or post tax, or whether it's added to your existing tax burden, or how these taxes actually get paid, etc.

I can imagine several possible scenarios here. For instance, assume you have a traditional IRA with a value of $100,000. Also presume you are in a very side 25% tax bracket so that the whole withdrawal would be taxed at 25% if it were simply classified as income (just to make calculations simple).

Do you pay a 10% penalty and then pay income tax on the rest? I.e.:
100,000 * .9 = 90,000 * .75 = $67,500 remaining.

Do you pay income tax on the whole thing and then pay a 10 penalty on the original amount as well?
100,000 * .75 = 75,000 - (100,000 * .1) = $65,000 remaining.

Do you pay income tax on the whole thing and then pay a 10% penalty on what's remaining?
100,000 * .75 = 75,000 - (75,000 * .1) = $67,500 remaining.

Do you pay an additional 10% in income tax?
100,000 * (1 - (.75 + .1)) = $65,000 remaining.

Clearly, some of these situations turn out equivalent, but there are still at least two possible ways to calculate this, and this information is perplexingly difficult to find online. What does the "10% penalty" actually apply to?

Also, if you do this, who is responsible for paying the taxes? Will the IRA administrator take out estimated taxes and pay the IRS at the time of distribution? Will they give you the entire withdrawal and leave it up to the person making the withdrawal to calculate the appropriate taxes at the end of the year? If the latter, do you need to pay some sort of special payment to avoid an under-witholding penalty at the end of the year?

posted by tylerkaraszewski to work & money (7 answers total)

It's 10% on the full amount, straight off the top.
And then the income tax you pay (whatever bracket rates apply) is on the full amount also.
So if the withdrawal falls into your 25% bracket, you'll pay a total of 35%.
Generally the administrator is not going to take out taxes, unless you have specifically arranged for withholding, and even then the 10% is probably not going to be included. If you are taking out a big lump sum, the administrator has no idea whether it's going to be a taxable distribution, because you might just be rolling it over to another account at another admin/investment manager.
posted by beagle at 9:48 AM on January 24 [1 favorite]

Also, keep in mind there are exceptions to the penalty for which you may qualify.
posted by beagle at 9:51 AM on January 24

You pay income tax on the whole thing and a 10% penalty on the whole thing. So from your example, you would pay $35,000 total and have $65,000 remaining. You can see how the penalty is calculated in Form 5329 -- it is 10% of the gross amount of the early distribution.

The administrator will withhold 10% unless you opt out - see here.
posted by payoto at 9:53 AM on January 24

Thanks Everyone. That's pretty straightforward. I have no idea why the 1,000 websites that mention the 10% penalty don't say this.
posted by tylerkaraszewski at 10:03 AM on January 24

Maybe you should pay a visit to a CPA, take your 1040s, estimated expenses etc. and they can help you figure out the best strategy for this. Or at least speak in person with whoever manages your IRA.

I withdrew some IRA money over the phone a couple of years running; they actually messed up once and failed to take it out on time for that year's taxes. Next time I'm going to get help.
posted by BibiRose at 10:24 AM on January 24 [1 favorite]

tylerkaraszewski, if this withdrawal is related to your wife's illness, definitely see an accountant who is an IRS enrolled agent to see if you can qualify for the exemption. The definition of "medical expenses" for this can be a bit more generous than for a yearly tax return.
posted by Sidhedevil at 11:53 AM on January 24

Yes, if there is no hardship exception, then you should figure it like this:

100,000 * 0.10 = 10,000
100,000 * 0.28 = 28,000

Total nominal tax owed = $38,000 (since .28 is the tax rate on 100,000)

They are probably going to withhold 25% automatically, so of the $75,000 check you receive, you'd need to put aside another $13,000 to cover the difference.

Now, what really happens is that you add your income for that year to the $100,000 to determine the actual tax.

Suppose your income is $50,000 (after deductions, for simplicity).

Your tax bill will be something like this:

100,000 * 0.10 = 10,000
150,000 * [tax table] = 35,617

Total tax for that year is $45,617. Then you subtract what was withheld from the withdrawal and your paychecks and that's what you owe on April 15th.
posted by gjc at 2:48 PM on January 24