As the prevalence of employer-based pension plans has declined, personal savings has become critical to achieving financial independence in retirement. For many people, individual retirement accounts (IRAs) are their primary retirement savings tool. Traditional IRAs offer tremendous savings advantages, since contributions are tax-deductible and accounts grow tax-deferred, with regular income tax due on withdrawals made after age 59 1/2. But, sometimes, financial circumstances arise that require use of IRA funds before that time. Though a 10% early withdrawal penalty generally applies to funds withdrawn from an IRA before age 59 1/2, for certain limited reasons you can tap your IRA early and not be subject to this penalty.
Remember that regular income taxes still apply to these withdrawals, though the 10% early withdrawal penalty will not:
- Education expenses: This includes the cost of college tuition, fees, books, and supplies for the IRA owner, or for a spouse, children, or grandchildren. If the student is enrolled at least half-time, the exception also applies to room and board. The school must be a college, university, or vocational school that qualifies for federal financial aid.
- First-time home purchases: You can withdraw up to $10,000 penalty-free from your IRA for a first-time home purchase ($20,000 for spouses when both are first-time buyers). The money may be used to purchase a home for the IRA holder and spouse, or for a child, grandchild, or parent. First-time home buyers are defined as those who haven’t owned a home for two years. This particular early use of IRA money can be advantageous, if used to make a larger down payment that results in a lower mortgage interest rate.
- Medical expenses: If you incur large medical expenses during the year, you can tap your IRA penalty-free to pay for them. The exception applies only to expenses that exceed 7.5% of adjusted gross income.
- Health insurance premiums: The exception to the penalty also applies to Health insurance premiums, but only if you’ve lost your job and have been collecting unemployment compensation for 12 consecutive weeks.
- Permanent disability: IRA owners who become permanently disabled before age 59 1/2 can take penalty-free distributions from an IRA.
- Annuity payments: If you annuitize all or part of an IRA over your lifetime, and take a series of payments for at least five years or until age 59 1/2 (whichever is longer), the payments will be penalty-free. However, if you find you no longer need the money before the payout period ends, you cannot stop the distributions without jeopardizing their penalty-free status. Consult with a tax professional if you’re considering using this somewhat complex option.
Of course, if you use your IRA funds early, they won’t be there for you in retirement, and tapping this nest egg even partially can impact future account growth significantly. Consequently, most financial experts advise using an IRA for non-retirement expenses only as a last resort. Explore other cash sources first, such as loans or a home equity line of credit. This money can be replaced as it is paid back.
If your financial need stems in part from a cash flow problem, you also can consider making an IRA withdrawal but then reinvesting the funds in another IRA within 60 days. The IRS will view such a transaction as a rollover, and the amount returned to IRA status will be both tax- and penalty-free. You can use this strategy only once in a 12-month period for any one IRA.