If you’re asking this question, then you’re most likely needing a financial boost and are wondering if your retirement funds are an option. While most financial advisors would recommend never touching your retirement funds unless in a true emergency, there are some circumstances where you may avoid penalty on an early withdrawal. Before discussing these, we will explain how an early withdrawal can hurt you more than just in penalties.
Penalties, Taxes, and Other Losses
If you take a distribution from your Traditional IRA before 59 ½ or take a distribution from your earnings in a Roth IRA before having the account for at least 5 years or age 59 ½, whichever comes later, then you will incur a 10% penalty on the distribution amount. So, if you take a $10,000 distribution, $1,000 will automatically go toward paying a penalty. Note, distributions on your Roth contributions are penalty-free at any time.
Besides the 10% penalty, you will have to also pay taxes on the amount distributed from a Traditional IRA. Be careful because the distribution counts as taxable income, and it could bump you up to a higher tax bracket depending on the amount withdrawn. You may also have to pay income tax on distributions made from a Roth IRA under certain circumstances. We’ll cover these in more detail below.
If those two points aren’t enough to scare you into keeping your retirement money where it’s at, consider the compounded interest you will lose out on if you take a distribution before retirement. Using the $10,000 example, in just 10 short years with a 5% interest rate that money could have grown to nearly $16,500 without any additional contributions. In 20 years, the number reaches to $27,000.
Remember, distributions aren’t always easily replaceable. Both Traditional and Roth IRAs have contribution limits of $6,000 per year (or $7,000 if you’re are 50 or older). This means you will only be able to replace about half of your distribution in the $10,000 example by the end of the year, if you haven’t met the limit already.
Exceptions to the Early Withdrawal Penalty
Luckily, there are a few exceptions to the 10% penalties, but you still may owe taxes and lose out on the compounded interest on your distribution. You can avoid the penalty and the taxes for a Traditional IRA or a Roth IRA distribution if you have had the Roth IRA for 5 years or more and:
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- Are 59 ½
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- You have suffered permanent or total disability
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- You are using up to $10,000 in a first-time home purchase
- You are inheriting the IRA from a deceased relative
You can avoid the penalty, but still owe taxes on a Traditional or Roth IRA if:
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- You are using the funds for a qualified education expense
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- You haven’t had the account for at least five years, but you meet one of the criteria from the previous list.
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- You are taking substantially equal distributions over a period of time
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- You are using the funds to pay a medical expense that exceeds 7.5% of your AGI
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- You are using the funds to pay for health insurance while unemployed.
- You are a member of the military and are taking a qualified reservist distribution.
Two last points to keep in mind. Rollovers do not count as distributions as long as you complete the transfer within 60 days. For the 5-year Roth rule, each contribution includes its own time clock. So, the most you can distribute in earnings is whatever was earned from the funds from at least five years ago, if you are younger than 59 ½ that is.