Used properly, the self-directed IRA is one of the most powerful tools you have to build a strong financial position for your retirement.
But there are also ways that you can tap into those funds prior to retirement without having to pay an early withdrawal penalty. Recall that the general rule for all IRAs is that any withdrawals you take before age 59½ will be subject to a 10% penalty (plus any taxes that may be due, depending on whether your IRA is a traditional or Roth account), unless your withdrawal meets one of several different exceptions.
These exceptions include withdrawing funds to buy your first home, to pay certain medical expenses or educational expenses, as well as a few others. As you might expect, each of these exceptions to the early withdrawal penalty come with a number of important requirements. If you’re considering making an early withdrawal pursuant to the terms of one of these exceptions, beware of the following traps.
Qualified Medical Expenses and Insurance. The early withdrawal penalty exception for medical expenses requires that your expenses (including medical expenses for someone in your immediate family) exceed 10% of your adjusted gross income for that year (or 7.5% if you or your spouse is 65 or older). But you cannot take an early withdrawal from your self-directed IRA for the full amount – only for the amount that exceeds the 10% (or 7.5%) amount. If you take an early withdrawal for the full amount of your medical expenses, you’ll be hit with an early withdrawal penalty.
A similar provision allows you to use funds from your self-directed IRA to pay for medical insurance premiums when you’re unemployed. But “unemployment” is defined to mean that you are actively receiving federal or state unemployment compensation for at least 12 consecutive weeks. If you don’t meet that definition, then using your account to pay for insurance can subject you to penalties.
Qualified Educational Expenses. One common penalty-free situation for early withdrawals is to pay for qualified educational expenses for yourself or a member of your family. But the educational expenses need to be “qualified,” which means that they’re related to the cost of attendance at an institution that is eligible for federal financial aid programs. In addition, funds withdrawn early from your account can be used for tuition, room and board, books and other required fees, but no other costs of living for the student.
Self-Dealing. The third early withdrawal penalty that’s important to be aware of is a bit broader in scope than the ones we’ve previously discussed. One of the fundamental prohibitions on any type of IRA is that there can be no “self-dealing.” This means that the account holder and their family cannot benefit from any funds or assets when they are held within the account.
So, for example, someone who holds real estate in their self-directed IRA cannot occupy it or in any way use that property before taking a distribution of it from their account. This means that if your self-directed IRA is invested in a vacation condominium, you can’t use that property before you retire.
Because the early withdrawal penalty can be significant, it’s vital that you stay clear of the traps discussed above.