Despite what many investors believe, there aren't many situations in which you can take money out of a traditional IRA early without significant consequences.
There are a few situations when you could possibly withdraw money penalty-free from your IRA, but they are very specific cases. For example, you can take an early distribution from your traditional IRA to pay large medical expenses or to help pay for your kids to go to college.
However, there are several popular misconceptions that deserve clarification.
For example, have you ever heard someone say they were going to "borrow from their retirement" to finance a big purchase? Don't try that with your IRA.
Here is a thorough explanation of this and a couple other things you can't do with your traditional IRA, as well as what can happen if you "mess up".
You can't "borrow" from your IRA
Sometimes you'll hear of somebody you know making a major purchase and saying they "borrowed from their retirement" to pay for it. However, this generally refers to a 401(k) or other employer-sponsored plan. While taking out a loan from your retirement savings is rarely a good idea, it's allowed in many plans.
However, the IRS specifically forbids owners of traditional IRAs from borrowing against their accounts, as well as lending money from their account to any other "disqualified person", which includes your family members.
Don't confuse this rule with the ability to invest in a business for profit. As long as the business owner is not a disqualified person, a self-directed IRA may give you the ability to lend money to a business and be paid back with interest. Just note that this is a complex situation and should be thoroughly examined by your financial advisor before considering an investment like this.
You can't use it to secure a loan
When applying for certain loans, like a mortgage, you might be required to state the balances of your retirement savings. However, you are not allowed to pledge any funds from your traditional IRA as collateral on any loan.
For example, if you want to purchase a boat, you can't put $50,000 of your traditional IRA assets up as collateral to secure the loan. If you do, that portion of your account is considered as a distribution by the IRS and can be subject to taxes and penalties.
You can't buy property to use
With a few exceptions; you can't use money from your traditional IRA to buy any property for your personal use, such as a vehicle, vacation home, or anything else.
However, the key phrase here is "for your personal use." There are plenty of acceptable ways to buy property for investment purposes in self-directed accounts. For instance, it's perfectly fine to use a self-directed IRA to finance the purchase of real estate that you intend to rent out.
There are some acceptable purchases, such as using up to $10,000 from your traditional IRA toward the purchase of your first home. You can also withdraw money penalty-free (but not tax-free) to pay qualifying higher education expenses for yourself or relatives. Other acceptable uses include large medical costs, health insurance if you're unemployed for a long period of time, or if you inherited the traditional IRA in question.
Bear in mind, however, that penalty-free doesn't mean tax-free. Even the qualified withdrawals will count toward your taxable income. For instance, if you withdraw $10,000 toward your first home and you're in the 25% tax bracket, you should expect to owe an additional $2,500 to the Federal government at tax time.
What happens if you "mess up"?
So, what if you withdraw money when you shouldn't? If you correct the mistake quickly, by redepositing the money, you might be alright.
On the other hand, if you conduct a prohibited transaction in your traditional IRA and don't reverse it promptly, the financial implications can be extremely severe, especially if you have a lot of money in your account. According to the IRS website, if your account is used in a prohibited transaction, the account will stop being an IRA as of the first day of that calendar year.
In other words, your entire account can be treated as a premature distribution. This means you'll have to pay income tax as well as a 10% early withdrawal penalty on either the entire account balance. If you have a traditional IRA worth a few hundred thousand dollars, it's easy to imagine the financial hit this could mean to your savings.
When it comes to your retirement savings, you're definitely better safe than sorry. Before withdrawing early for any reason, make sure to consult a tax or retirement professional to be sure that whatever you're doing is allowed.
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