Early Withdrawals from your IRAs
By now you’ve heard everyone encouraging you to save for your own retirement. Max out your contributions. Put money into a Traditional IRA or a Roth IRA and let the interest, dividends and gains compound over time and you’ll end up with a bunch of money at retirement. So why would you want to take money from these accounts early?
It is considered an early distribution if you take a withdrawal before age 59 ½ and there is a 10% penalty on top of the income tax on the withdrawals. However, the IRS will waive the penalty if you are using one of these exceptions:
- First-time homebuyer: You can withdraw $10,000 from your account without penalty. You’ll be considered a first-time homebuyer if you have not owned a home in the two years preceding buying a new one.
- Education expenses: Qualified higher education costs for college avoid the 10% penalty. The rules are similar to 529 plans for tuition, room & board, books, etc. Remember that your IRA is meant to pay for your retirement. If you use funds from this account for your child’s education, make sure your retirement savings is on track first.
- Medical expenses: The medical expenses that cannot be reimbursed by insurance and must be over 10% of your adjusted gross income.
- Disability: if you have total permanent physical or mental disability and are unable to work. The actual definition is pretty strict where you are unable to ‘engage in any substantial gainful activity’ that lasts indefinitely, is long-continued or until death. You will also need to get documentation from your doctor.
- Equal Payments: if you have a series of substantially equal payments from your IRA, this can avoid the penalty. To do this, you’d need to take distributions for at least 5 years or until you reach age 59 ½, whichever is later. The calculation of the distributions can be complex, so talk with your accountant for guidance.
- Qualified Reservist: The penalty is waived for distributions if you are on active duty for more than 179 days.
- Health Insurance Premiums: If you’re unemployed, withdrawals from your IRA can pay for your health insurance You’ll need to have been collecting unemployment for 12 consecutive weeks. If you’ve met the criteria, the penalty is waived here too.
For Traditional or Roth IRAs, these exemptions are waiving the penalty, but not the income tax. Remember that if you’re taking funds from a Roth IRA, your own contributions come out first both tax and penalty-free. After that, your early distributions would have a tax on the earnings. Withdrawals from a Traditional IRA will come to you as ordinary income.
So, should you use your IRAs for something other than retirement? I took advantage of the $10,000 for the first-time home buyer from my IRA and it was nice to have a little more as a down payment. The additional income tax, however, was not so nice! Make sure you have funds to pay the taxes, too. It’s always best to save for goals such as college education or keep enough cash in an emergency fund for medical expenses or insurance premiums, but if you need the funds and this is your only resource, at least with these exemptions, having the penalty waived takes away a little of the sting.