Hardships When Closing an IRA
- Closing your IRA is an option available at any age for any reason. Those meeting normal distributions rules don't pay the 10 percent IRS tax penalty for early distribution. The normal distribution rules are simple: reach age 59 1/2 and hold the IRA for at least five years in the case of a Roth IRA only. The 10 percent penalty is applied to the taxable distribution. For the traditional IRA, the taxable distribution is the entire distribution. For the Roth, earnings are taxable in early distributions, added to income and penalized. The IRA custodian also might have closing fees or liquidation fees on the investment. The custodian provides the paperwork for closing your IRA.
- The IRS has certain distributions with penalties waived, referred to as hardship distributions. If you don't meet normal distribution requirements and qualify for a hardship distribution, you only pay the income taxes on the IRA closure. Hardship distributions include using funds to pay medical expenses not covered by insurance and exceeding 7.5 percent of annual income. You may use IRA funds if you lose your job and need to pay medical insurance. Payments made if you become permanently and completely disabled qualify as hardship distributions. Additionally, using funds to pay college expenses or using $10,000 for a first home are exempted from penalties.
- When money is taken out of an IRA before the normal distribution eligibility, a Form 1099-R is sent by the IRA custodian to you and the IRS; traditional IRAs receive this form regardless of what type of distribution it is. The form states how much was taken out and the taxable portion. The taxable portion listed in Box 2 is used when filing income taxes and is added to modified adjusted gross income. You also must complete Form 5329 to record the early distribution. This form establishes any penalty waiver for which you qualify. It also calculates any penalties that might apply.
- Closing a Roth IRA has special considerations regarding what is taxable. Recall that all funds put into the Roth are after-tax dollars. These dollars will not be taxed again, even upon early distribution. Furthermore, the IRS views contributions and converted dollars as the first money to be distributed. Since only earnings are taxable, you have access to the entire principal value of the Roth IRA tax free. If you convert $50,000 that grows to $75,000 and don't meet normal distribution eligibility, you can access the first $50,000 at any time. When the $25,000 in earnings is taken out, it is added to income taxes even if you qualify for a waiver. If no waiver exists, this is penalized 10 percent, too.
