Make an early withdrawal from an IRA and you may be hit with a 10% tax penalty.
But that's a bigger "may" than you might think.
Financial advisers generally warn against tapping an individual retirement account early, and not just because of the potential tax penalty. There's also the loss of any investment gains that could have been racked up by the money that's withdrawn. "If you have other assets, use them" instead, says Maria Bruno, senior investment analyst at Vanguard Group.
But if you must tap an IRA early, the good news is that there are several exceptions to the tax penalty.
Here's what you need to know.
First, what are the basic rules on the taxation of IRA withdrawals?
If all your contributions to your traditional IRA were tax-deductible, all your withdrawals will be taxable as ordinary income. If you made some after-tax contributions as well, a part of each withdrawal may be tax-free. (We'll talk about Roth IRAs, which are funded only with after-tax dollars, separately below.)
Taking a distribution from an IRA before age 59½ generally incurs a penalty—an additional 10% of the taxable amount.
There are several specific exceptions to that penalty, though. And if you don't qualify for one of those, you may be able to avoid the penalty by taking a series of payments from the IRA over several years.
What are the specific exceptions to the 10% penalty?
If you have lost your job and collected 12 consecutive weeks of state or federal unemployment compensation, you can use money from an IRA at any age, without penalty, to pay health-insurance premiums. There also is no penalty if an early distribution goes for qualified higher-education expenses, such as college or vocational-school tuition for yourself, your spouse, your children or grandchildren, or your spouse's children or grandchildren.
You can withdraw up to $10,000—$20,000 for a couple—penalty-free to buy, build or rebuild a first home, and that, too, applies for children and grandchildren. There also is an exception if the money goes to pay for unreimbursed medical expenses greater than 10% of your adjusted gross income (7.5% if you or your spouse was born before 1949). You also would be exempt from the penalty if you become disabled before you are 59½.
There are some additional exceptions and in some cases conditions to qualify for an exception. For more information see Internal Revenue ServicePublication 590.
How do the periodic payments work?
You can avoid the 10% penalty by taking a series of roughly equal payments over five years or until you are 59½, whichever is longer, making at least one withdrawal annually. But calculating how much you can take is complicated. Even the IRS says you may want to consult a financial professional.
The amount depends on which of the three IRS-approved calculation methods you choose, all based on life expectancy—either yours alone or yours and your beneficiary's. The simplest calculation method is known as required minimum distribution, or RMD—something of a misnomer because it results in the exact amount that must be withdrawn, not a minimum. The amount must be recalculated every year, changing with your age and any fluctuations in the account balance.
You generally can get a larger annual amount using one of the other methods—fixed amortization or fixed annuitization—which require only a one-time calculation. Because those calculations are "complex and generally require professional assistance," the IRS doesn't provide details in Publication 590. It does, however, answer some frequently asked questions, with examples of the calculations, elsewhere on its website, irs.gov, which you can find by searching "substantially equal periodic payments" either on the site or through a search engine. Vanguard has a brochure that may be helpful, which is available on its website, vanguard.com, using the same search term or its acronym,SEPP. (To view the entire brochure, scroll down from the first page.)
You can switch from one of the fixed-payment calculation methods to RMD, but only once, and you may have to wait until a new calendar year. You can't switch from RMD to one of the other methods.
What if my IRA is a Roth IRA?
With a Roth IRA, contributions are made with after-tax money, and for those over 59½ who have had the account for at least five years, withdrawals aren't taxable. Before the five-year period is over, the earnings portion of a withdrawal is subject to income tax.
But if you're younger than 59½, even if you pass the five-year test, the earnings portion of a withdrawal may be subject to taxation, plus a 10% penalty if you don't qualify for an exception. The exceptions are the same as those for a traditional IRA, including withdrawals used for qualified higher education or a first-time home purchase, for health-insurance premiums if you are unemployed, or if you become disabled before age 59½.
One good thing to know is that money withdrawn from a Roth is treated as coming from contributions first, so you won't owe any tax—or the penalty—as long as you take out less than you've put in. It's important to keep good records.
What documentation do I need to report an early withdrawal to the IRS?
As with all IRA distributions, the mutual-fund company or other financial institution holding your IRA will send you a Form 1099-R early in the year listing your withdrawals for the previous year, and the information also is sent to the IRS. These forms generally are coded to indicate an early withdrawal if that's the case.
For the distribution to be penalty-free, you generally must file Form 5329 with your federal income-tax return indicating which exception you are claiming. In some cases you may be asked to provide documentation of your eligibility.
Ms. Jasen is a writer in New York. Email her at reports@wsj.com.