An individual retirement account is designed to help you save money for the future while enjoying some tax perks. With a Traditional IRA the main benefit is the potential to deduct your contributions (and have them grow tax-free until retirement). With a Roth IRA, you get a tax break in the form of the same tax-free growth plus tax-free distributions in retirement. An IRA is designed to be used for long-term savings. Generally, taking money out of your account early can trigger a 10 percent early withdrawal penalty, not to mention the regular income tax you may have to pay on what you withdraw. There are, however, some situations under which you can take money from an IRA while avoiding the early withdrawal penalties.
What Counts As an Early Withdrawal?
Generally, an early withdrawal is any withdrawal you make from an IRA before age 59½. Once you hit that milestone, you can withdraw money from an IRA without any penalty. Roth IRAs have an additional requirement known as the five-year rule, but with a Roth you can always withdraw contributions (not earnings) tax- and penalty-free.
Again, if you’re taking money from a Traditional IRA, you’d pay ordinary income taxes on the distribution. And at age 70½, you’re required to begin taking minimum distributions from a Traditional IRA. If you don’t, you could face a tax penalty of 50 percent of the amount you’re required to withdraw. Aside from the benefit of tax-free withdrawals in retirement, a Roth IRA doesn’t have a minimum distribution requirement.
Avoiding Early Withdrawal Penalties
If you don’t meet the age requirement to avoid a penalty, all is not lost. The IRS allows you to take money from an IRA without a penalty if the withdrawal qualifies for an exception. Here’s what the list of exceptions includes.
- You become disabled. The IRS will waive the 10 percent penalty if you need to break into your IRA early because you’re permanently and totally disabled.
- You need to pay for qualified education expenses. If you have a child who’s headed off to college, you can use IRA money to cover the cost. You can avoid the penalty on IRA early withdrawals if you’re paying for qualified education expenses such as tuition, fees, books or room and board, and your child is going to a school that’s eligible to participate in federal student aid programs.
- You’re buying a home. Buying a home takes money and if you need cash for the down payment or closing costs, you can withdraw up to $10,000 from an IRA penalty-free. The catch is that you must use the money for homebuying expenses within 120 days of the withdrawal and you can’t have owned a home in the previous two years.
- You’ve got hefty medical bills. If a serious health issue results in a pile of medical bills, you can use money from an IRA to pay for those expenses penalty-free. The expenses must exceed 10 percent of your adjusted gross income to qualify for the exception.
- You’re stuck covering your own health insurance premiums temporarily. Losing your job can be a pain in the wallet, especially if you have to keep up with your health insurance coverage until you find a new position. Fortunately, you can withdraw money from an IRA without penalty to pay for the premiums if you’ve been receiving unemployment compensation for at least 12 weeks.
- You’re called to active duty. Military reservists can get around the early withdrawal penalty if they take an IRA distribution while they’re serving on active duty for 180 days or more.
- You owe Uncle Sam. If you have an unpaid tax bill, the IRS can levy your retirement account to collect, but it won’t tack on the additional early withdrawal penalty.
- You’re taking “substantially equal payments.” One final way to avoid the penalty is by taking substantially equal payments from your IRA. Essentially, you agree to take a set amount from your IRA each year for a period of five years or until you reach age 59½. Just be careful to weigh the pros and cons before you start taking the payments. If you try to change or reverse your payment plan, the 10 percent penalty would kick in.
Does an Early Withdrawal Make Sense?
Withdrawing money from your IRA might seem like the best option when you’re crunched for cash, but it’s important to think about the big picture. Any money you withdraw is money that isn’t earning any kind of return. When your nest egg growth gets thrown off-course, that can affect your long-term retirement outlook.
Also, you need to be aware that just because you avoid a penalty doesn’t mean you can avoid income tax on early withdrawals. With a Roth IRA, for example, you could still end up paying taxes on the earnings from an early withdrawal if it doesn’t fit one of the exception rules. Talking with a trusted financial advisor or tax professional can help you decide whether an early withdrawal makes sense and what tax implications there may be, if any.