Individual retirement accounts, or IRAs, are terrific instruments for planning your future. Traditional IRAs allow you to invest tax-deferred income in stocks and bonds, where it grows tax-free until retirement. Roth IRAs invert the taxation mechanism, placing taxed earnings into accounts for tax-free distributions. Self-directed IRAs, which can be in traditional or Roth configurations, blow the lid off investment restrictions and open unorthodox but often lucrative avenues for growth.
Whether they’re traditional or Roth, self-directed or conventionally managed, one thing is true: the IRS wants your contributions to stay where they are until they’re ready. In more colorful terms, the IRS sees IRAs as financial loaves of bread that must stay in the oven and fully rise before you take them out. Withdrawals before age 59 ½ are considered early. Though there may be exceptions, you should be aware of the dangers of early withdrawals from an IRA before you pull funds prematurely.
Loss of Principal
It may seem obvious, but it’s worth restating that when you take money out of your IRA, it can no longer earn more money for you. Part of what makes IRAs so alluring is the building of compound interest. Interrupting the steep growth that compound interest provides has serious long-term ramifications for the value of your IRA. Contributing $30,000 to your IRA over four years with an initial investment of $6,000 and a maximum annual contribution of $6,000 per year at a modest rate of 7.5 percent growth yields nearly $36,000—a real growth rate of 19 percent. In ten years, $66,000 would become just over $100,000. Would you dare tamper with this?
Early Withdrawals Are Taxable Income
When you invest in a traditional IRA, the expectation is that being in a lower tax bracket in retirement will mean lower tax obligations that you would have faced in your working years. Early withdrawals become taxable income for this year, and that tax rate can be steep. Because Roth IRAs are after-tax, you may “retrieve” a contribution tax-free, but if you withdraw earnings prematurely, that income will be taxable.
Early Withdrawal Penalty
Traditional IRA holders not only pay income taxes on early withdrawals—they also face the wrath of the IRS in the form of a penalty. Alongside becoming taxable income, early withdrawals incur a ten percent penalty. For instance, a $5,000 withdrawal would carry a penalty of $500 to the IRS for interfering in the IRA’s growth. Roth IRA holders face penalties on earnings they withdraw early.
Penalty Exceptions
Despite the dangers of early withdrawals from an IRA, there are exceptions to the onerous penalty. Withdrawals for post-secondary education, medical hardship, and home construction, as well as withdrawals from inherited IRAs, don’t carry penalties. They do, however, become taxable income before that critical age of 59 ½. If you can afford to let your “dough” finish rising, do so.
