3 Reasons Not to Take Money Out of an IRA Early

If you have money in an individual retirement account (IRA), you can technically withdraw funds before retirement age, but it’s usually not a good financial move. IRAs are designed as long-term retirement accounts that allow you to grow your money until you’re at least 59½.

If you withdraw money before then, you’ll have to pay income taxes on those funds for that tax year and pay a 10% penalty on the amount you took out. Perhaps the biggest disadvantage is the loss of earnings that you would have made as your investment appreciated. Here are three reasons not to take money out of an IRA early.

Reason # 1: Penalties

Unlike a savings account, you can’t simply pull money out of a traditional IRA without paying a penalty. Each time you withdraw before the age of 59½, you’ll face a 10% federal tax on the distribution.

Furthermore, you might face additional state tax penalties, depending on your state’s tax laws. However, once you reach age 59½, you can withdraw funds penalty-free.

There are some situations when the Internal Revenue Service (IRS) allows you to withdraw money from an IRA before age 59½ without a tax penalty, including:

• You’re adopting or paying for a qualified birth (up to $5,000 distribution)
• The IRA owner dies or becomes permanently disabled
• You experience a federally-declared disaster where you live (up to $22,000 distribution)
• You’re a victim of domestic abuse (up to the lesser of $10,000 or 50% of the account)
• For qualified higher education expenses (like tuition, fees, room and board, textbooks, and other required expenses)
• To help pay for personal or family emergency expenses (up to $1,000 per calendar year)
• You’re purchasing a home for the first time (up to $10,000 distribution)
• You’re in the reserves and called to active duty

Reason # 2: Taxes

In addition to the early withdrawal penalty, you must count the amount you withdrew as income for the year. In other words, your withdrawal amount gets added to your overall annual income, putting you at risk for a higher tax bill.

Since a traditional IRA is a tax-deferred account, providing an upfront tax deduction in the year you contributed the money, you must pay income taxes on the funds when you withdraw the money. Also, you’ll likely be in a higher tax bracket during your working years than your retirement years, so taking out the money early can really cost you.

Reason # 3: Impact on Your  Retirement Savings

As with many retirement savings accounts, your best asset is time. The longer you keep your money in the account and contribute to it, the more money you’ll earn in compound interest.

For example, if you open an IRA with $1,000 and it earns 5% interest that compounds per year, you’ll earn $50 the first year. At the start of the second year, you’ll earn 5% on $1,050, and in the third year, you’ll earn 5% on $1,102.50, and so on.

If you pull your funds early, you miss out on earning interest. The opportunity cost can be significant since we’re talking about years or even decades of earning compound interest. Also, you may have a challenging time catching up with your contributions.

As a result, you may not have the funds you need to retire comfortably, which can translate to a lower standard of living in retirement, or you may need to work longer.

The Bottom Line

If you’ve got a large amount of money in an IRA, it can be tempting to take funds out if you have an emergency or are making a large purchase. However, this can be a costly mistake since you’ll pay a penalty and a higher tax bill, as well as lose out on earning compound interest.

Instead of taking from your IRA, consider withdrawing from a different savings account (if you have one), taking out a personal loan, or borrowing from the equity you have in your home. If you’re hoping to make a large purchase and need funds, research installment payment plans or loans that may be available.