What are the Different Types of IRA Penalties?

Jessica Ellis

An individual retirement account (IRA) is a common means of saving for retirement. The benefits of an IRA include tax-deferred or tax-free contributions, which can help an investor save more money in the long run. There are some downsides to using an IRA to save for retirement, including several different types of IRA penalties. Understanding the different types of IRA penalties can help avoid losing valuable savings to accounting accidents or mistakes.

Businessman with a briefcase
Businessman with a briefcase

Since IRAs are meant to fund retirements, there are usually early withdrawal IRA penalties if money is taken out before the account holder has reached a certain age, generally 59.5 years. Almost all IRA systems have an early withdrawal penalty, usually of about 10% of the withdrawn amount. There are several exceptions to these IRA penalties, including the use of withdrawn funds for non-refundable medical expenses, higher education, first-time purchase of a house, or in the event of the death or permanent disability of the account holder.

Some IRA accounts, like the popular Roth IRA, are subject to IRA penalties known as five-year rules. This means that an account must be funded for five years before withdrawal can be made without penalty, even if the account holder is over the minimum age for penalty-free withdrawal. Essentially, this prevents a person from opening an IRA account at 58 years of age and withdrawing the money penalty-free at the minimum age of 59.5.

Some IRA accounts are tied to income, meaning that there is a maximum contribution per year based on an account holder's income level and age. It is possible to incur IRA penalties if contributions exceed the maximum limit in a given year. This penalty is easy to accidentally incur if income levels increase midyear. Since maximum contribution levels fall to zero for high earners, accidentally over-contributing can occur before the change in income happens. The usual penalty for an excess contribution is a 6% annual tax on the excess amount.

Avoiding IRA penalties is generally a matter of following the rules and keeping careful account records. As long as a withdrawal meets both the age requirement and the five year requirement, it is extremely unlikely to incur any penalties. Before choosing to open an IRA, it is important to review all possible penalties and be certain that a budget can handle the contributions without being in regular danger of having to tap into the account early and thus lose earnings. While an IRA can be an excellent way to maximize retirement funds, falling victim to penalties can eat away at rainy day funds very quickly.

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