Example showing the effect of taxes and penalties on your IRA

Income taxes on IRA and retirement plan distributions can really add up. When a distribution is also subject to the 10 percent federal penalty, the portion of the distribution that goes into your pocket obviously dwindles even further. To illustrate the possible effect of taking a distribution before age 59½, consider the following scenario.

Example(s):    Joe retired on his 59th birthday. On that day, he withdrew the entire balance in his traditional IRA valued at $100,000. The entire distribution was taxable. Because Joe also had considerable income from working that year, the IRA distribution was taxed in the maximum 35 percent federal income tax bracket. That came to $35,000 in federal income tax (assuming no other variables). Joe was in the 9.3 percent state income tax bracket, so that meant another $9,300 in state income tax. Since Joe was under age 59½ and no exception to the premature distribution tax applied to him, he had to pay $10,000 in federal penalties (the 10 percent federal penalty tax), plus another $2,500 in state penalties (due to a 2.5 percent state penalty). He ended up paying $56,800 in taxes and penalties, leaving only $43,200 for his own use.

If Joe had waited until he was 59½ or older to take his distribution, he would have avoided the federal and state penalties and saved $12,500. Also, if he had waited two months until the next year (when he had no taxable income from working), the distribution might have been taxed in a lower income tax bracket. It would definitely have paid for Joe to get tax advice before taking that distribution from his traditional IRA.

Of course, if Joe had ever made any nondeductible contributions to his traditional IRA, the portion of his distribution that represented nondeductible contributions would not have been taxable because those contributions had already been subject to tax. That portion of his distribution would not have been subject to the 10 percent federal penalty either, since the penalty applies only to the taxable portion of a premature distribution.

If you are close to age 59½ and wish to take a distribution from your traditional IRA, check the calendar carefully to avoid a potentially costly mistake.