Once you contribute money to an IRA, you're not allowed to withdraw it before you turn 59 1/2 or you face a 10% early withdrawal penalty on top of income tax. However, there are a few exceptions to this rule. If you need money for a qualified reason and you don't have the cash or credit to cover it, a dip into your IRA can be tempting, but this is often not savvy for your savings.
What seems like only a few thousand dollars today can add up to tens or even hundreds of thousands of dollars down the road. Here's a closer look at IRA early withdrawals and how they can affect your retirement savings.
Exceptions for early withdrawals
The government allows several exceptions to the 10% early withdrawal penalty. If you use the funds to pay for college tuition and related college expenses, you don't have to pay the penalty. The same goes for distributions of up to $10,000 that go toward a first-time home purchase, medical expenses that exceed 10% of your adjusted gross income, health insurance expenses following 12 consecutive weeks of unemployment, and living expenses if you become disabled.
It's worth noting that if you're withdrawing money from a traditional IRA, you still have to pay income taxes on your distributions, even if they are made for one of the qualifying reasons listed above. Traditional IRA contributions are tax deferred, which means you don't pay any taxes on the money in the year that you contribute it to the account, but you have to pay taxes on your distributions, or the amount that you take out. Roth IRAs contributions, on the other hand, are taxed the year you earn the money, but you pay no taxes on distributions.
How early withdrawals affect your retirement savings
It may seem convenient to be able to draw upon your retirement savings now, but you'll pay for it in the long run. When you spend the money you were saving for retirement, you're slowing the growth of your nest egg by losing out on compound growth of your invested money.
Imagine you make a $5,000 withdrawal from your IRA to put toward the purchase of a first home. If you withdraw that money today, you'll receive $5,000. But if you leave it in your retirement account, it will be worth $38,000 in 30 years, assuming a modest 7% rate of return. And the more you borrow, the more significant the difference becomes. If you borrow the full $10,000 that you're allowed for a first-home purchase, you'll miss out on the $66,100 that you would have had if you'd left the money in your IRA.
Alternatives to IRA early withdrawals
The best thing you can do to avoid IRA early withdrawals is to build up an emergency fund. This should contain three to six months' living expenses. If you have an unexpected medical emergency or you are laid off, you can fall back on this money instead of taking a distribution from your IRA.
If you know you have a big purchase like a home coming up, set aside a little money each month to work toward the down payment. You could also consider a personal loan if you need the money immediately, but the interest rates may make this route unappealing. Borrowing from family or friends is another option if you can find anyone willing to lend to you.
If you absolutely cannot avoid taking an early withdrawal from your IRA, borrow only the amount that you need and make sure you're prepared for the consequences. If it's a traditional IRA, remember that you'll owe more in taxes at the end of the year. Then do your best to make up for the withdrawal by making regular, and increasing, contributions to your IRA in the future.