The purpose of an IRA is to provide an income stream during retirement, and while there are certain situations that allow you to take early withdrawals without incurring a penalty, you'll need to think long and hard before tapping your account prematurely. Here, we'll review some key IRA withdrawal rules so that you can develop a strategy for accessing your money.
Roth versus traditional IRA withdrawals
Distribution rules vary greatly between Roth and traditional IRAs, so the type of account you have will impact your withdrawal strategy. Traditional IRAs are funded with pre-tax dollars, but in exchange for that initial tax break, you must leave your money in your account until age 59 1/2. Otherwise, you'll incur a 10% early withdrawal penalty unless you qualify for an exception, which we'll get into in a bit. Once you turn 59 1/2, you can withdraw your money as you wish, but your distributions will be taxed as ordinary income.
Roth IRAs work differently. Roth accounts are funded with after-tax dollars, so there's no immediate tax break for contributing. But unlike traditional IRAs, Roth distributions are tax-free in retirement. Furthermore, you can actually withdraw your principal contributions to a Roth IRA at any time, for any reason, without incurring that 10% penalty. If you withdraw the earnings portion of your Roth before 59 1/2, you might face a penalty, but because the IRS treats Roth withdrawals as initially coming from contributions and then from earnings, that penalty is avoidable much of the time.
Another key difference between traditional and Roth IRAs is that traditional accounts are subject to required minimum distributions (RMDs) once you turn 70 1/2. Roth IRAs impose no such requirement, so you're free to let your money sit and grow in your account indefinitely.
When to withdraw from an IRA
Now that you know the rules regarding IRA withdrawals, let's talk about when you should start accessing your money. The short answer is this: Unless you absolutely need that money sooner, you shouldn't touch it until you officially enter retirement, regardless of which type of account you have. While you can easily remove money from a Roth account in your 30s or 40s without worrying about a penalty, if you go that route, you may come to have an even greater concern on your hands -- not having enough money to pay your living costs as a senior.
That said, if the purpose of your IRA is to save for something other than retirement and you have another retirement plan, like a 401(k), that you're committed to leaving alone, then you can safely withdraw money early from an IRA for the right reason.
We just learned that Roth IRAs offer the flexibility to take penalty-free early withdrawals, but you can also withdraw from a traditional account penalty-free prior to 59 1/2 if you qualify for an exception. One such exception is to cover higher education costs for either yourself, a spouse, or a dependent. Another is to pay for medical expenses that exceed 10% of your adjusted gross income. You can also avoid a penalty if your early withdrawal is used to pay your health insurance premiums during a period of unemployment. And finally, you're allowed to withdraw up to $10,000 penalty-free to pay for a first-time home. If you're married, in fact, you and your spouse can each take a $10,000 withdrawal from your respective IRAs for a total of $20,000 toward a home.
Let's say you're maxing out a 401(k) plan at work and you decide to open an IRA for the purpose of saving for college. If you choose to tap that account in your early 50s to cover tuition costs, so be it -- you weren't counting on that money in retirement anyway. But if your IRA is your sole retirement savings vehicle, you're better off leaving that money alone and finding other ways to address your immediate financial needs. You can always apply for student loans or take on a slightly higher mortgage, but you can't as easily (or affordably) borrow money to pay your living costs as a senior.
Remember, too, that when you withdraw funds early from an IRA, you're not just losing out on the principal amount you remove in retirement; you're also losing out on whatever growth that money could've achieved. Imagine you take a $10,000 distribution at age 35 to buy a home and retire 30 years later. Let's also assume that your IRA investments generate an average 7% return over the life of your account. At age 65, you won't just be short that $10,000; you'll be short $76,000, because that's what your initial $10,000 would've grown into over the course of 30 years. Now that's a lot of money to be missing at a time in your life when every dollar counts.
Pay attention to required minimum distributions
While taking an early IRA withdrawal could have unfortunate financial consequences, neglecting to take your RMDs in time could hurt you even more. You're required to take your initial RMD by April 1 of the year following the year you turn 70 1/2. You can take your RMD either as a lump sum or in equal payments throughout the year. Fail to comply by the appropriate deadline, however, and you'll be hit with a 50% penalty on the amount you should've withdrawn but didn't. So if your RMD (which is based on your account balance and life expectancy) is $5,000 and you don't take any of it in time, you'll lose $2,500 right off the bat.
Again, if you have a Roth IRA, you won't have to worry about RMDs. But if you have a traditional IRA, you'll need to not only plan for RMDs but the taxes they automatically trigger. Remember, traditional IRA withdrawals are treated as ordinary income, so if your ordinary income tax rate is 25% and your RMD is $5,000, you'll be liable for $1,250 in taxes.
Your IRA could spell the difference between paying your bills in retirement and running into financial trouble as a senior, so be sure to save consistently and time your distributions appropriately. The smarter you are about IRA withdrawals, the more likely you are to avoid penalties or run out of money later in life.