Know the consequences of an early IRA withdrawal

The financial impacts of taking an early IRA withdrawal

As with your workplace retirement plan, an IRA can provide tax incentives for building retirement savings. Also like your workplace plan, the tax rules for IRAs are designed to encourage you to use your savings in your retirement years. And so, they include penalties for those who take their money early (with some exceptions).

Get to know the potential taxes and penalties for early withdrawals from a traditional or Roth IRA. As you’ll see, it can be a costly way to cover a short-term expense—and it may be worth thinking twice about it, if other alternatives are available.

Costs of withdrawing early from a traditional IRA

Regular income taxes

Regardless of your age, you’ll likely owe income taxes on at least part of your withdrawal from a traditional IRA.

If you contributed on a pretax basis to the IRA—or rolled money in from a workplace retirement account—you’ll pay regular taxes on any of these contributions that you withdraw.

On the other hand, if you fund your IRA solely with after-tax contributions (i.e., non-deductible contributions), you’re allowed to withdraw up to the amount you put in without paying further taxes. But be aware: You must report these after-tax contributions on Form 8606 to the Internal Revenue Service (IRS) each year to preserve their tax-free status. Also, it’s advisable to keep a copy for your records.

Early withdrawal tax penalties

If you’re under age 59½ when you withdraw from your IRA, you’ll generally end up owing an additional 10% penalty tax on the total amount subject to income taxes; however, the IRS penalty tax will generally not apply for withdrawals:

• Taken due to death or disability
• Used for qualified higher education expenses, a qualified first-time home purchase ($10,000 limit), unreimbursed medical expenses that exceed 7.5% of your adjusted gross income, or to pay health insurance premiums when you’re unemployed
• Taken by qualified military reservists called to active duty or domestic abuse victims
• Taken as a series of substantially equal payments that you commit to taking for five years or until you reach age 59½, whichever comes second
• Taken to cover birth or adoption expenses, personal emergency expenses, or disaster recovery expenses (subject to IRS limits)

For a complete listing of exceptions, check out the IRS website.¹

What happens when you withdraw early from a traditional IRA?

Let’s see what can happen when someone who hasn’t met the conditions for a penalty-free withdrawal withdraws $10,000 from a traditional IRA 20 years before their expected retirement date.

Withdrawing $10,000 today would require paying federal taxes, a 10% early withdrawal tax penalty, and (depending on where you live) state taxes. This could put a sizable dent in the withdrawal amount.

Keeping the $10,000 working in a traditional IRA can allow for continued growth and may be worth $33,000 (before taxes) in 20 years, assuming annual growth of 6%. Although taxes will still come due when you withdraw your savings, you may be in a lower tax bracket during retirement—meaning you'd get to keep more of each dollar withdrawn.

This is a hypothetical mathematical illustration only and there are no guarantees that the results shown will be achieved or maintained over any period of time. Figures are based on assumptions as set out, it is not indicative of any particular investment, and does not take into account fees associated with the investment. Past performance does not guarantee future results. Individual circumstances may vary.

Costs of withdrawing early from a Roth IRA

The whole concept of a Roth account is to put after-tax money in, then withdraw both your contributions and any accumulated growth tax free in retirement.² This makes the tax treatment of early withdrawals different from a traditional IRA.

The Roth IRA five-year rule³

Under IRS rules, tax treatment on withdrawals is determined in part by when you began saving in Roth IRA accounts. After you’ve been saving for five years, you’ve met the conditions for the five-year rule. In general, your five-year period begins on January 1 of the year you opened your first account, regardless of the actual date.

This same rule applies to Roth conversions—that is, the conversion of a traditional IRA to a Roth IRA. And if you inherited a Roth IRA, the original owner’s five-year start date still applies (that is, the clock doesn’t reset when you inherit the account).

Potential taxes and penalties on early Roth IRA withdrawals

Your Roth account is designed to provide totally tax-free withdrawals at or after age 59½ provided you've satisfied the five-year rule; therefore, taking money out at an earlier age or before you’ve satisfied the five-year rule may trigger income taxes as shown below.

For illustrative purposes only.

Why you may want to think twice before taking an early IRA withdrawal

It takes hard work and discipline to save and invest in a retirement account, but one reason you did it was to give your money a chance to grow over time with the help of tax advantages.

Unless you qualify for an exemption, current year taxes and penalties can end up costing you a quarter to a third of the money you withdraw from your account. Even with an exemption, you’ll lose out on the chance for compound growth on every dollar you withdraw.

Alternatives to tapping onto your IRA for short-term needs

The following options may be able to help you meet a large, unexpected expense without putting your retirement nest egg at risk.

An emergency savings account—Financial experts suggest keeping enough to cover three to six months of your household’s monthly expenses in an account that’s safe and easy to access. An emergency savings account is an option worth considering for handling unexpected expenses.

Rethink your budget (at least temporarily)—You may find the cash you need by rearranging or reprioritizing your spending.

A home equity loan or line of credit—Because it leverages the value of your home, this type of loan can have lower interest rates than other options.

A personal loan—This type of loan may let you borrow a lump sum of money at a lower-than-credit card rate that’s based on your credit rating.

Credit cards—Although they allow for purchases or cash advances, credit cards are intended to meet short-term needs and tend to have higher interest rates than other options, and the debt can add up if you're unable to pay them off quickly.

Do the math before you take the cash

Life is unpredictable, and everyone faces financial decisions that involve some kind of trade-off.

But before you rush into taking an IRA withdrawal, take the time to weigh the full costs of doing so. This can include money lost to taxes and penalties—and a lost opportunity for potential long-term growth on your retirement savings.

You may find that handling the expense another way is better for your budget and your financial future.

1 You'll find the IRS exceptions at https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions. 2 Distributions from Roth accounts must be “qualified” for both the contributions and earnings to be treated as tax free. Certain conditions would apply. See your plan document for more details. All references to tax-free treatment of qualified distributions are intended to refer to the treatment of such distributions at the federal level only. You may want to consult a professional tax advisor regarding any tax issues discussed. 3 A qualified distribution from a designated Roth account in the plan is a payment made after the participant attains age 59½ (or after death or disability) and after the designated Roth account in the plan has been established for at least five years. In general, in applying the five-year rule, count from January 1 of the year the first contribution was made to the designated Roth account. Participants should contact their plan consultant or financial or tax advisor for specific details on the five-year rule and whether any special rule may apply.