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Considering Withdrawing from an IRA Early? Read This First

Post on April 11, 2023 in Blog

Considering withdrawing from an IRA or other investment account to cover emergency expenses? You’re not alone.

In a recent study by Wells Fargo, 29% of U.S. adults said they would withdraw from an IRA or 401(k) if not for the tax penalties. And in October, nearly 25,000 Vanguard 401(k) holders took early withdrawals—the most reported by the firm in a single month since tracking began in 2004.

But could taking money out of an IRA or other retirement account early do more harm than good in the long run?

Here, we’ll cover IRA withdrawal rules and other related considerations so you can make an informed decision. Plus, we’ll touch on actions you can take now to (hopefully) avoid withdrawing from your IRA or other qualified account.

Key Takeaways

  • Understand IRA withdrawal rules: Different rules apply to traditional and Roth IRAs, and knowing these can help you avoid penalties and taxes.
  • Be aware of early withdrawal exceptions: Certain circumstances may waive the early withdrawal penalty, but consult with a tax professional for specific guidance.
  • Compound interest is key: Withdrawing early from your IRA can disrupt the long-term growth potential of your investments.
  • Explore alternative strategies: Establish an emergency fund, consider loans, use your HSA, or take on a side gig to avoid early IRA withdrawals and safeguard your financial future.

When Can You Withdraw from an IRA?

The rules for early IRA withdrawals differ slightly between traditional IRAs, which are tax-deferred, and Roth IRAs, which are tax-free. It’s important to understand the rules associated with both types of IRAs before considering an early withdrawal. 

Traditional IRA Withdrawal Rules

In general, you can withdraw from a traditional IRA without penalty once you reach the age of 59½. At this point, you must pay ordinary income taxes on the amount withdrawn, since the contributions were made with pre-tax funds. 

However, if you withdraw funds from your traditional IRA before age 59½, you’ll be subject to a 10% early withdrawal penalty on the amount withdrawn. This is in addition to any income taxes due on the withdrawal.

Roth IRA Withdrawal Rules

Withdrawal rules for Roth IRAs differ from Traditional IRA rules in that you can withdraw Roth IRA contributions (the money you put into the account) tax-free and penalty-free at any time, regardless of your age or how long the account has been open. 

However, withdrawing earnings before meeting specific criteria can lead to a 10% tax penalty and income taxes on any investment earnings. To withdraw earnings tax-free and penalty-free, you must meet both of the following conditions:

  • You must be at least 59½ years old when making the withdrawal.
  • You must have a funded Roth IRA for at least five years.

In both instances, you may need to complete a 5329 tax form and attach it to your tax return. These penalties are designed to discourage you from accessing your investments before reaching retirement age, as doing so can have a detrimental impact on your financial future due to missing out on valuable compound interest. 

IRA Early Withdrawal Penalty Exceptions

There are specific circumstances in which the early withdrawal penalty may be waived, as outlined by the IRS. Understanding these exceptions is crucial if you’re considering an early withdrawal from your IRA. 

With the passage of the SECURE 2.0 Act of 2022, some of these exceptions have been expanded or adjusted. Some notable exceptions include:

  1. Unreimbursed medical expenses exceeding 7.5% of your adjusted gross income (AGI) for the year
  2. Premiums for health insurance paid during a period of unemployment
  3. Qualified higher education expenses 
  4. A permanent disability resulting in the inability to work
  5. Buying a home for the first time, up to a lifetime limit of $10,000
  6. Being called to active duty for more than 179 days
  7. Surviving domestic abuse, the lesser of $10,000 or 50% of your account balance (beginning in 2024) with the ability to repay withdrawals to the IRA within three years of the distribution.

Each of these exceptions has specific requirements and limitations, so consult with a tax professional if you have questions about how these rules apply to your unique circumstances. Keep in mind that while these exceptions waive the 10% tax penalty, distributions will still be taxed as ordinary income (unless there is an option to repay the IRA, and repayment occurs by relevant deadlines).

By being aware of these exceptions, you can make informed decisions about whether an early withdrawal from your IRA is a viable option for you.

Read more: Can I Borrow From My IRA to Buy a House? 3 Reasons You Probably Shouldn’t 

Establish a Long-Term View of Your Investments

One key to financial performance is to establish a long-term view of your investments, and that means recognizing the importance of compound interest in growing your retirement savings.

Compound interest is the process by which your initial investment earns interest, and then that interest earns interest on itself, resulting in exponential growth over time. 

By withdrawing funds early from your retirement account, you not only incur penalties and taxes (save for certain exceptions), but you also lose out on the potential for substantial growth over the long term. 

In light of this, it’s crucial to exhaust all other financial avenues before considering an early IRA withdrawal. By doing so, you’ll ensure that your investments continue to benefit from the most valuable component of the compound interest equation: Time.

Remember, the decision to withdraw funds early from your IRA should always be a last resort, as the long-term impact on your financial future could be more detrimental than the short-term relief it may provide.

Read more: Splurging or Saving? The Gen Z Luxury Dilemma and the Power of Compound Interest Unleashed

Alternative Strategies to Avoid Early IRA Withdrawals

Exploring alternative strategies to avoid early IRA withdrawals is essential in safeguarding your long-term financial well-being. 

Consider the following approaches, as recommended by GOBankingRates:

  • Establish an emergency fund: Create a separate account specifically for emergencies, ideally containing three to six months’ worth of living expenses. 
  • Take out a loan: Consider personal loans or home equity loans, which may offer lower interest rates compared to credit card debt.
  • Leverage your HSA for past medical expenses: Use your Health Savings Account (HSA) to make tax-free withdrawals for previously incurred medical costs.
  • Consider a side gig: Taking on a part-time job or starting a side hustle can generate additional income, helping you cover urgent financial needs without resorting to early withdrawals from your retirement accounts.

Of course, not everyone can implement these strategies, particularly if they’re already in the midst of an emergency situation. However, it’s crucial to consider these options before you find yourself in a financial crisis, so you’re better prepared to navigate unexpected challenges without resorting to early IRA withdrawals. 

Planning ahead and establishing financial safeguards can make a significant difference in preserving your investments and building a more secure financial future.

Early IRA Withdrawal Final Considerations

While withdrawing from an IRA or other retirement account may seem like a tempting solution to cover emergency expenses, it’s crucial to weigh the long-term implications of such a decision. 

By understanding the rules, penalties, and exceptions associated with early withdrawals—and considering alternative strategies for financial emergencies—you can make informed choices that protect your future.