IRA individual retirement account. Stack of money and calculator.
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The Covid-19 pandemic has left millions of people out of work, and while the extended unemployment benefits are helpful, they may not be enough for everyone. If you find yourself in a financial bind, you might be curious about tapping your individual retirement accounts for extra cash.
Unfortunately, it’s not always easy to access your IRA funds without paying a hefty price. You can expect to pay a 10% early withdrawal penalty on funds you withdraw before retirement age. In addition, you will be required to pay taxes as soon as you withdraw the funds from a traditional retirement account (no taxes are due on withdrawals from Roth accounts, but you may still be required to pay penalties). This combination can leave you with much less than you were expecting when you made the withdrawal.
However, there are times you can withdraw the money from an IRA without paying that 10% penalty (you might still have to pay taxes on the money). Before you move forward, though, carefully think about the consequences. One of the biggest downsides to withdrawing money early is that you lose time in the market. It’s very difficult—and sometimes impossible—recover that opportunity cost.
But, if you’re in a pinch and hoping you can access the money in your IRA, here are five times you can avoid the penalty.
1. Healthcare costs
If you’re struggling to cover healthcare costs that aren’t covered by insurance (or if you don’t have insurance), you might be able to withdraw money from your IRA without penalty. There are some caveats, though.
First, you have to pay the medical expenses during the same year as the withdrawal. On top of that, any unreimbursed expenses must be more than 7.5% of your adjusted gross income (AGI). You can only withdraw the amount above that 7.5% threshold.
Let’s say your AGI is $100,000. You have $10,000 in medical expenses that weren’t covered by insurance. Because 7.5% of your AGI is $7,500 you can only take a penalty-free distribution of money above that threshold, so you’re limited to taking $2,500 without penalty.
2. Permanent disability
When you qualify for permanent disability, it’s possible to take the money from your IRA without paying the penalty. However, you usually need to show proof of the permanent disability before proceeding. When you’re in this situation, being able to draw on your IRA can be very helpful, especially when combined with other resources that might be available to you.
3. Buying a Home
If you decide to buy a home, you can take up to $10,000 from your traditional IRA without paying a penalty. But, as you might expect, there are requirements.
First of all, you can’t have owned a home in the last two years, so you can’t use the money to buy a second home or upgrade from your current home. Next, it’s important to understand that the $10,000 in a lifetime limit. So if you withdraw all of the $10,000 this time, as a down payment, you won’t be able to withdraw anymore for home buying in the future.
Finally, funds must be used within 120 days of withdrawal. So be sure to wait until right before your closing date to make the withdrawal to make sure you don’t exceed the time limit.
4. Paying for higher education
Going back to school? It’s possible to use the money in your IRA to pay for qualified expenses like tuition, books, fees, and supplies required by enrollment. As long as your program qualifies, you’re in school at least half-time and the expenses are qualified, you can avoid paying the 10% penalty for early distribution.
This also applies if you are helping a spouse or child pay for college. However, it’s rarely a good idea to put your retirement in jeopardy to help your child pay for schooling. As so many have pointed out in the past, your child can get loans for college, but you can’t get a loan for retirement.
5. Roth IRA contribution withdrawals
With the Roth IRA, the rules are different. Because Roth contributions are made with after-tax money, it’s possible for you to withdraw the money you put it in at any time, for any reason, without paying a penalty.
However, you need to be careful to avoid withdrawing the earnings in your Roth IRA. Once you withdraw the earnings early, you might be subject to that 10% penalty from the IRS. Carefully calculate before you withdraw in order to make sure you aren’t withdrawing your earnings. Here are more Roth IRA withdrawal rules to help you better understand what you can and cannot do without paying a penalty.
Bottom line
There are other ways to avoid paying a penalty on early IRA withdrawals, such as receiving an inherited IRA, Reservists being called up for active duty, or taking substantially equal periodic payments. However, before you take any steps to withdraw money early from an IRA, it’s important to fully understand the requirements so that you don’t end up running afoul of the IRS and paying a penalty on top of having the distributions taxed as income.
In most cases, it’s probably best to come up with another way to get the money you need if possible. Once you take money out of an IRA, for the most part, you can’t just put it back (unless you meet certain criteria). That money is gone from your retirement account and is no longer earning compounding returns.
Because withdrawing money early from an IRA can impact your long-term retirement goals, it’s important to carefully weigh the pros and cons before moving forward, even if you can avoid the 10% IRS penalty.