Individual retirement accounts (IRA) can act as a savings supplement to an employer-sponsored retirement plan, and more than one-third of U.S. households owned at least one IRA in 2019. Collectively, retirement savers held $9.7 trillion in their IRAs, making up 11% of all household financial assets. The accounts’ tax-advantaged status is a large part of their appeal.
“With IRAs, you have the advantage of growing the assets and deferring paying taxes as long as you don’t plan on making withdrawals before age 59½,” says Abigail Gunderson, Certified Financial Planner and wealth advisor at Tanglewood Total Wealth Management in Houston.
IRAs are designed for long-term investing, but some savers opt to tap their accounts before retirement. The most commonly cited reasons for early withdrawals include buying a home, paying for higher education, covering medical expenses, paying for financial emergencies, and paying off debt.
While an early withdrawal can provide you with much-needed cash flow, it can have significant financial consequences.
Tax Impact of Early IRA Withdrawals
Withdrawing from an IRA before retirement can trigger tax penalties, depending on which type of IRA the withdrawal comes from and what the money is used for.
Withdrawing funds early from a traditional IRA could bump you into a higher tax bracket, says Andy Whitaker, vice president of Gold Tree Financial in Jacksonville, Florida. “All distributions are included as income in the current year, which will add to their current wages,” he says. “Additionally, if those distributions are made prior to age 59½, a 10% early withdrawal penalty may apply.”
Here’s an example to illustrate just how much that may cost. Assume you’re 50 years old and withdraw $50,000 from your traditional IRA. You fall into the 24% income tax bracket, which means you owe approximately $12,000 on the withdrawal. You’d also owe an additional $5,000 for the early withdrawal penalty, resulting in a total tax bill of $17,000. That’s a steep premium to pay.
Early Withdrawal Exceptions
Whether you’ll pay an early withdrawal penalty hinges on your reason for an IRA withdrawal.
“There are exceptions that will allow taxpayers to avoid the 10% penalty based on facts and circumstances,” says Mitchell Helton, senior wealth strategist at PNC Wealth Management.
Those circumstances include withdrawals for:
- Higher education expenses paid directly to the school
- First-time home purchase, up to $10,000
- Total and permanent disability of the IRA owner
- Death of the IRA owner
- Health insurance premiums paid while unemployed
- Unreimbursed medical expenses greater than 7.5% of adjusted gross income
- Distributions to military reservists called to active duty
- IRS levy
- Substantially equal periodic payments
You would still, however, be responsible for paying income tax on withdrawals for the purposes listed above.
Roth IRA Early Withdrawal Rules
While traditional IRAs are funded with pre-tax dollars, Roth IRAs are funded with after-tax contributions. That alters their tax treatment for early withdrawals. “If you’re under 59½, you may withdraw as much as your total contributions without incurring any taxes,” Gunderson says.
Whether you pay income tax or a 10% early withdrawal penalty hinges on whether the distribution is qualified. Helton says qualified distributions must meet one of the following criteria:
- Taken five or more years after the account was opened
- Taken at age 59½ or older
- Used to buy or build a first home
- Taken because of a disability
- Taken by a beneficiary after the death of the account owner
Early withdrawals made before the five-year window may be subject to the 10% early withdrawal penalty. You’d also pay income tax on any earnings you withdraw.
Early IRA Withdrawals Can Shrink Retirement Savings
Aside from the tax impact, you must also consider whether an early IRA withdrawal might shortchange your long-term savings goals.
“Tapping an IRA early will often lead to a lower retirement lifestyle upon retirement,” Whitaker says. “If you reduce the size of your chicken, you will reduce the size of your eggs, meaning you will reduce your income-generating assets for retirement.”
Here’s another example. Say you’re 50 years old, with $500,000 in your IRA. You plan to retire at age 65, and your assets are currently earning a 7% annual rate of return. If you don’t contribute anything further to your IRA, your account could grow to nearly $1.4 million by retirement. Withdrawing $50,000 at age 50, however, would trim almost $200,000 in lost earnings off your savings total.
Considering other borrowing alternatives, such as a home equity loan, can spare your retirement savings.
“Advantages of the home equity loan might include being in a low interest rate environment, not paying income taxes, no potential penalties on an IRA distribution and the interest on the loan might be tax-deductible,” Helton says. Under new IRS rules, interest on home equity loans is deductible when those funds are used to substantially improve your primary residence.
While they each have pros and cons, credit cards, personal loans, or borrowing from friends and family can also provide needed funds in the short-term.
“It’s usually without exception that early tapping of an IRA should be the last resort, only after all other options have been fully exhausted,” Whitaker says.
The Bottom Line
Talk to your financial advisor or accountant about the potential tax impact if you’re contemplating an early IRA withdrawal. Most importantly, focus on adding new contributions to your IRA moving forward.
“The key is to commit to putting the money back,” Gunderson says. She also recommends building up your emergency reserves to avoid the need for additional early withdrawals in the future.
“We typically recommend saving an amount that can cover at least three months to a year’s worth of living expenses,” Gunderson says. “When emergency situations arise, you’ll have a rainy day fund that you can easily tap with minimal tax consequences.”
Read the original article on Investopedia.