You may have found yourself in a tough financial spot, or you may just really want to go on a nice vacation this year, and your only extra funds are tied up in your IRA. It’s tempting to borrow from your retirement, but there are several costs to consider before you book any flights to Italy. You can take distributions from an IRA without penalty once you’ve reached 59 ½ years of age, or have had a Roth account for at least 5 years regardless of age (on contributions only, not earnings). Of course, there are a few exceptions to this rule which are explained further below. However, if you do not qualify for one of these exceptions, the penalties for early distribution can be severe.
- Early distribution penalty. If you haven’t reached that 59 ½ mark, an early distribution can cost you 10% in fees on the amount you withdraw. If it’s from a traditional IRA, you will also have to pay taxes on top of that 10% penalty. Even with a Roth IRA that you’ve had for at least 5 years, you won’t be able to withdraw on earnings until you reach 59 ½. You can, however, withdraw on contributions at any age as long as the account is at least 5 years old.
Exceptions to the early distribution penalty include using the funds to pay for college, medical expenses that exceed 10% of your AGI, medical insurance if you’ve been collecting unemployment for at least 12 weeks, a first time home, and income lost due to a work-ending physical disability. You may also take early withdrawals if you’re an active duty member of the military, if you’ve inherited an IRA and haven’t rolled it over into your own account, or if you need money long-term and utilize the Substantially Equal Periodic Payment plan.
- Catch-up later not an option. Because IRAs have yearly contribution limits of $5,500, you may be prevented from replacing those borrowed funds at a later date depending on the size of the sum. You can take advantage of “catch-up contributions” after age 50, but it only increases the limit by $1,000 each year. If you’ve withdrawn $20,000 or more, you won’t be able to replace that amount by the time you reach 70 ½ when RMDs are required. Not to mention, you will lose out on the compounded interest on those funds as well.
- Forfeit compounding interest. Even if you manage to avoid the 10% early withdrawal fee, you will still end up losing a significant amount of money in compounded interest those funds would have earned in the long run. Even a modest distribution could cost you tens of thousands of dollars in retirement.
- Higher tax bracket. If you aren’t careful, a large distribution from a traditional IRA can bump you up to a higher tax bracket which can cause you to owe even more than the initial 10% penalty and original tax amount on your funds. Some people don’t realize IRA distributions count as income, and an early withdrawal ends up costing them a lot more than they previously thought it would.
While there are legitimate reasons to take an early distribution on an IRA, they are few and far between. The account holder must weigh every cost before making a decision one way or the other. Most financial advisors recommend leaving IRA funds alone until you’re 59 ½ because the costs almost always outweigh the benefits. If you aren’t sure what’s right for you, your financial advisor can provide you with a more personalized look into how your account will be affected by an early distribution.