Because individual retirement arrangements provide tax benefits to invest for retirement, the Internal Revenue Service frowns on taking money out of these accounts before you reach age 59 1/2. Pre-retirement withdrawals can trigger a tax penalty of 10 percent. To make sure you avoid this penalty, the money you are withdrawing must be for a specific, qualified purpose. You can also avoid the 10-percent penalty by withdrawing money you have contributed to Roth IRA.
1. Buy a principal residence for the first time. As long as you have not owned a home for the previous two years, you can withdraw up to $10,000 in your lifetime to pay construction, acquisition, settlement and closing costs, among others, for a new home.
2. Use your distribution to pay for excessive medical expenses. Withdrawing IRA funds to cover medical expenses that add up to more than 7.5 percent of your adjusted gross income will exempt you from the early withdrawal penalty. You will still be liable for ordinary income tax on the amount of the withdrawal.
3. Use early IRA withdrawals to pay for health insurance premiums while you are unemployed. Such a use will keep you from paying the penalty, but ordinary income tax will still be due.
4. Finance higher education expenses, such as tuition, fees and supplies, with your early distribution. You can even use the money to cover qualified higher education costs for your spouse, your children or your grandchildren. Room and board costs can be covered if the student is enrolled in a degree program on at least a half-time basis. Ordinary income tax on the distribution will need to be paid.
5. Withdraw principal from your Roth IRA. IRA distributions of principal are allowed at any time from Roth IRAs because the money has already been taxed. To withdraw earnings without penalty, however, you must satisfy the same requirements as for a traditional IRA. If any one of your Roth IRAs has been open for at least five years, you can avoid both tax and penalties on distributions if you become disabled, pass away or use up to $10,000 in Roth funds to purchase a first home. You must also satisfy the five-year rule to avoid penalties on withdrawals to cover excessive medical expenses, qualified higher education costs or health insurance premiums while unemployed.
- To avoid tapping your IRAs at all, consider other sources, such as borrowing against life insurance policies or from a 401k. Consult a tax attorney or financial professional to find out if negative tax consequences will arise from any option.
- Borrowing from an insurance policy can involve steep interest rates and reduce the dividend earned on the cash value of your account. Life insurance policies vary so greatly, it is difficult to generalize about the potential pitfalls. Be aware that hidden costs may increase the effective interest rate and reduce the death benefit. Before taking out a loan, find out from your insurance agent everything you can about the terms and any potential negative consequences.
- A 401k loan may have a minimum and may involve an origination fee. In addition, repayments are typically deducted on a regular basis from your paycheck over the life of the loan. Moreover, the loans are generally made at a fixed rate set on the day of issue. On the upside, depending on your 401k plan specifics, you may be able to borrow up to 50 percent of your vested balance up to a maximum of $50,000. Separate terms may apply to loans made to buy a home.
- If you take money out of an IRA, you can only replace it up to the annual contribution limit, which as of publication is $5,000 if you are under 50 or $6,000if you are 50 or older.
- graduate girl image by Maria Bell from Fotolia.com