Opening an IRA is a good way to build retirement savings. And there are numerous tax breaks you'll reap for funding one. With a traditional IRA, your contributions are tax-free, and investment gains are tax-deferred until retirement. With a Roth IRA, investment growth is tax-free, and withdrawals aren't taxed either.
But in exchange for these tax breaks, the IRS imposes some pretty strict rules about when you can and cannot access your money. And if you take an IRA withdrawal prior to age 59 1/2, you'll be liable for a 10% penalty on that distribution, which is akin to throwing money away.
That said, there are a few circumstances under which you can access your IRA funds prior to age 59 1/2 and avoid that dreaded penalty. Here are a few you should know about.
1. Buying a first-time home
Saving up for a down payment on a home can prove challenging, but if you have an IRA, you can remove up to $10,000 for a first-time home purchase. If you're married, and your spouse has his or her own IRA, he or she can do the same so that collectively, you have $20,000 to put toward a home. The 10% early withdrawal penalty won't apply here as long as you're a first-time homebuyer, which the IRS actually defines as having not owned a home during the two-year period prior to your withdrawal. But if you owned a home seven years ago, sold it four years ago, and haven't purchased another one since, you're good to go.
Furthermore, the home you buy doesn't have to be for you. You can withdraw that $10,000 from your IRA penalty-free to help a child, grandchild, or parent buy a home as well.
2. Paying for higher education
College is an expense prospect these days, so if you don't have savings to pay for it, you can use your IRA instead. The 10% early withdrawal penalty won't apply if you use that money to pay for qualified education expenses for you, a spouse, or a child. And by "qualified expenses," we're talking not just tuition, but supplies, books, fees, and even room and board, provided the student in question is enrolled at least half-time.
3. Covering health insurance premiums while unemployed
Losing your job doesn't just mean losing your paycheck; it also means losing out on health coverage. It's common for employers to subsidize insurance premiums, so once you're forced to cover them on your own, you may find that it's prohibitively expensive. The good news is that the IRS allows you to withdraw IRA funds penalty-free to pay those health insurance premiums while you're unemployed, thereby easing that particular burden during a financially rocky time.
Think twice before you raid your IRA
While the above scenarios allow you to take an early IRA withdrawal without incurring penalties, whether it's wise to do so is a different story. The purpose of an IRA is to save for retirement, so the more money you withdraw from that account before that milestone, the less you'll have as a senior, when you really need it.
Furthermore, when you take an early IRA withdrawal, you don't just lose out on the principal amount you remove; you also lose out on growth from compounded investment returns. Imagine you take a $10,000 withdrawal to buy a home at age 27. If you're not retiring until 67, and your IRA investments typically generate an average annual 7% return (which is a reasonable assumption for a stock-heavy portfolio), then you'll actually end up losing out on $150,000 in retirement income when you account for not just that $10,000 distribution, but also, 40 years of growth on it.
If you're stuck in a dire financial situation, like being out of work and having to pay for health insurance completely out of pocket, then you may have no choice but to tap your IRA (though ideally, you should have an emergency fund to help in that scenario). But withdrawing funds to buy a home isn't necessarily a smart move. You're generally better off waiting a bit longer to buy so you can save up the down payment you need.
Similarly, raiding your IRA to pay for college isn't a great option, especially when there's affordable borrowing available in the form of federal student loans. And while graduating college with debt may not be ideal, at least the option to borrow exists. Borrowing money to pay your basic living expenses in retirement, on the other hand, is less feasible, and while you can technically do so by falling back on credit cards, that's an extremely expensive, unhealthy way to compensate for a lack of savings.
Remember, the "R" in IRA stands for "retirement," so do your best to reserve the money in that account for your senior years. You'll be thankful you did when you're older.