Think Twice About Withdrawing from Your IRA
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Most people don't plan to remove money from their retirement funds before they're supposed to. It defeats the purpose of saving in a retirement plan in the first place, and in many cases, you'll face penalties for doing so.
However, most people also don't expect the sudden hospital expense, the lost job or the credit card debt that forces them to take an early withdrawal. That's one of the reasons 29% of Americans who participate in a retirement plan have taken out an early loan from that plan, according to a survey conducted by TIAA-CREF. But of that group, 44% admit they regret the decision.
People considering taking an early withdrawal from their retirement funds need to carefully consider the ramifications it will have on the money they withdraw and on their long-term retirement savings. We've already covered 401(k) loans in a separate post; here you will learn about the effects of taking an early disbursement from your IRA.
Can I take an IRA loan?
Unlike a 401(k), you cannot take a loan from your IRA. An individual retirement account is similar to a 401(k) in that it's a fund for money set aside for retirement. However, IRAs are typically managed by the associated individual, not an employer, unless you're self-employed and have a SEP IRA. IRAs are subject to different rules than 401(k)s, and understanding those differences is important.
What about rollovers?
Some people will claim that you can use a 60-day rollover of your IRA as a form of short-term loan. Individuals should be cautious with this advice.
A rollover is the transition that occurs when you move funds from one retirement plan into another, such as you would if you're moving money from your old employer's 401(k) to your personal IRA after you leave the company. When initiating a rollover, you may be able to choose a direct, institution-to-institution rollover, in which you'll never touch the funds. This is the easiest method. A second option is to choose to receive a disbursement in the form of a check, which you must then deposit into the destination fund within 60 days.
Theoretically, you could use this cash for those next two months, as long as you can recoup it and deposit it into your destination fund in time. However, if those 60 days pass and you still don't have the the cash on hand to deposit into the destination fund, the entire IRA balance will be converted to taxable income for the year, and you'll also face a 10% penalty on the balance.
Additionally, when you choose this method, your originating fund manager may be required to withhold 20% for taxes. When you deposit the money 60 days later, you'll need to come up with that additional 20% on your own, and you won't get the 20% your originating fund manager withheld until you file your taxes the coming year.
All of these stipulations create a messy situation for someone who is already short on cash, so treating an IRA rollover as a loan is inadvisable.
Can I just withdraw the money?
While you can't take a loan from your IRA, you can withdraw the entire balance. Generally, any IRA withdrawals before the age of 59½ will convert the entire IRA into a taxable investment account, terminating its valuable tax benefits. Also, you'll face the 10% early withdrawal penalty.
However, there are a few exceptions.
- Roth contributions:A Roth IRA is funded with post-tax dollars, so there is no additional tax applied when withdrawing those funds. You can always withdraw the contributions you've made (but not their earnings) without penalty.
- First home purchase:The IRS allows each individual to withdraw up to $10,000 from their IRA without penalty if those funds are used within 120 days for a first-time home purchase. These funds can also be used for a mortgage down payment for a parent, spouse, child or grandchild. However, your IRA needs to be at least at least five years old before you're allowed to make such a withdrawal. If you're withdrawing from a Roth IRA, this $10,000 withdrawal may be in addition to any post-tax contributions you made and subsequently withdrew.
- Qualifying education expenses:If you, a spouse, a child or a grandchild is attending an accredited, postsecondary educational facility that meets federal student aid program requirements, you can withdraw as much funds as is necessary to pay for qualified educational costs, such as tuition and textbooks. If the student is enrolled at least half-time, you can also use these funds to pay for room and board. As with a home purchase, your IRA needs to be at least five years old before you qualify for such a withdrawal.
These exceptions create a few tolerable options for somebody in a financial bind. However, you should keep in mind that, except in the case of a rollover, money removed from an IRA can't be put back. And since the government caps the total amount you can put into an IRA each year, you may permanently reduce the amount you'll have to live off of in retirement. Because of this limitation, taking out a 401(k) loan for something like a home purchase is preferable to an IRA withdrawal—as long as you pay it back on time or earlier. In either case, you should carefully consider all other financial options before reducing your retirement funds.