Texas Life Agent Practice Exam

What tax implications are associated with premature distributions from a Traditional IRA before age 59 1/2?

1. Only ordinary income tax

2. Ordinary income tax plus a 10% penalty

3. No tax implications

4. Penalty only

The correct answer is: Ordinary income tax plus a 10% penalty

When a distribution is taken from a Traditional IRA before the account holder reaches the age of 59 1/2, the IRS generally imposes specific tax implications. The distribution is subject to ordinary income tax because the contributions made to a Traditional IRA are typically made with pre-tax dollars. Therefore, when those funds are withdrawn, they are taxed as ordinary income in the year they are distributed. In addition to the ordinary income tax, there is also a 10% early withdrawal penalty applied to the amount withdrawn. This penalty serves as a deterrent against accessing retirement funds prematurely, thereby encouraging individuals to leave their retirement savings intact until they reach the prescribed retirement age. There are certain exceptions to the penalty for early withdrawals, such as for individuals who become disabled or incur significant medical expenses, but the general rule is that any premature distribution will lead to both ordinary income tax and a 10% penalty. This dual taxation framework is crucial for individuals to understand as they plan for any early withdrawals from their retirement savings.