Withdrawing From A Traditional IRA: How It Works, Penalty Exemptions And Drawbacks
Traditional IRAs are funded with pretax or tax deductible dollars, meaning that you don’t pay taxes on the income that you put into your IRA. When you retire and begin taking money out of the account, you’ll pay regular income tax on your withdrawals (also called distributions).
Basically, with a traditional IRA, you won’t pay taxes right now; you’ll pay them later.
Who Is Eligible For A Penalty-Free IRA Withdrawal?
To get the most out of your retirement savings, you won’t want to withdraw from your IRA before reaching retirement age.
If you take money out of your traditional IRA before you reach the age of 59 ½, not only will that money be counted as taxable income, but you’ll also typically be subject to an additional 10% penalty tax if you aren’t taking that money out for one of the situations the IRS allows exceptions for.
First-time home buyers are allowed an exception to this rule. The IRS defines a first-time home buyer as someone who hasn’t owned a home in the last 2 years. If you’re married, your spouse has to meet this requirement as well.
Withdrawals can also be made without having to pay the 10% penalty following the death or disability of the IRA owner, to pay for college tuition and other higher education-related costs, to cover medical expenses or to pay your health insurance premiums if you’re unemployed.
If you are age 59 ½ or older, you can withdraw penalty-free at any time. Once you reach age 72 (the law was recently changed from age 70 ½), you’ll have to take a required minimum distribution each year.
How Much Can I Withdraw?
If you’re a qualified first-time home buyer, you’ll be allowed to withdraw up to $10,000 from your IRA penalty-free.
This is a lifetime limit. For example, if you used $6,000 to fund a home purchase several years ago and you qualify for the first-time home buyer exemption again, you’ll only be able to withdraw $4,000 if you want to avoid the 10% penalty.
If you’re 59 ½ or older, you aren’t restricted on how much you can take out – keep in mind, however, that these distributions are considered taxable income.
What Are The Drawbacks?
As more people live into their 90s and beyond, many of us can’t afford to be shortsighted about retirement. When you withdraw from your retirement savings, you’re borrowing from your future financial security.
While a home purchase can also be an important part of building financial security and long-term wealth, it’s important to carefully consider the risk you’re taking and the potential growth you’ll be missing out on when you withdraw from your IRA.
Thanks to the power of compound interest, your money earns you more money when you keep it parked in a retirement account. When you take funds out of that account, you’re cutting into the amount you could end up with when it’s time to retire – potentially losing out on a significant amount of money.
Additionally, if you don’t qualify for the first-time home buyer exemption, you’ll have to pay the hefty 10% penalty on your withdrawal in addition to regular income tax.
However, that’s not to say that using your IRA to fund a down payment on a house is always a terrible idea that nobody should ever even consider. If you’re still a long way out from retirement and have time to make up for the money you take out or you have other retirement savings and feel comfortable with how much you have saved, you might find that this option makes sense for you.
If this is something you’re considering, it’s always a good idea to talk with a financial advisor who can evaluate your individual situation and help guide you to a solution that works best for you.