IRA Withdrawals: The Good, the Bad, and the Ugly

by Jennifer Garrett

Don't dip in

It shouldn't come as a surprise that there would be a cost to raiding retirement funds early. When the IRS lets you forgo paying income tax on current earnings, as it does with IRA contributions, it attaches a few strings. The most obvious of these for IRAs is the age requirement. You must be 59½ before you receive IRA distributions without paying a 10% penalty.

Unfortunately, not everyone waits. Some consumers tap into IRAs early to pay down credit card debt. Others dip in after long periods of unemployment, divorce, or other personal crisis.

"People don't have any other type of savings in a lot of cases," says Pat Sokolowski, a certified financial planner with Sokolowski Investment Advisors in Burlington, Vt. "They should be setting up some emergency fund account, but people don't do that. So as soon as they run into problems, they go into their only source of savings, which happens to be their IRA or [another] retirement account."

Americans, it turns out, aren't that bad at saving for retirement. The Employee Benefit Research Institute's 2012 Retirement Confidence Survey found that nearly 60% of Americans currently set aside money for their golden years. The same study also found that, of the 74% of workers whose employers offered a workplace savings plan, 81% took advantage of it.

But Americans are not quite as good at saving for other purposes. While most financial consultants recommend socking away anywhere between three and nine months of living expenses for job loss or other emergencies, most of us don't do it. A recent Bankrate survey found that just over half of us have more savings than credit card debt, while a quarter have more credit card debt than savings. Sixteen percent of folks have no savings at all. When someone like that loses a job or suffers some other costly personal crisis, he or she often has no funds other than retirement savings to turn to.

Penalties can add up

Taking early distributions from an IRA might seem harmless at first. After all, it's your own money and a 10% penalty doesn't sound too steep. But financial experts say it's never a good idea.

"Never under any circumstances should an IRA be considered a backup savings account," says Cynthia Meyers, a certified financial planner in Sacramento, Calif. "It should be monies for the long term...withdrawing from the IRA [is something I consider] a last resort."

That's because IRA money withdrawn early is expensive money. In addition to the 10% IRS penalty for early withdrawal, some states—such as California—tack on their own penalty, commonly about 2% to 3%. The federal and state taxes together can easily approach 40%. Add it all up, and withdrawing $10,000 from an IRA can cost as much as $5,000—you pay around 50% in taxes and penalties. So if you need to end up with $10,000, you'll need to withdraw closer to $20,000.

"It's a real expensive way to solve the problem," says David Jackson, a financial adviser with Waddell & Reed in Kansas City, Mo.

And that's only the upfront cost. There also is an opportunity cost, or the time value of money, to consider. If you withdraw $10,000 from an IRA, your retirement savings will take an even bigger hit because you'll miss out on compounding earnings. So if you think $10,000 won't make that much difference when you're 65, think again. If you're 42 now, a $10,000 withdrawal will actually cost you $30,715 in 23 years—and that's assuming a modest 5% rate of return.

Sokolowski says the average person doesn't calculate the long-term effects or expense. "It's a substantially larger nut, [and it's] even bigger if you assume a rate of return that's higher than 5%."

"I'll pay it back next month...or next year"

Sometimes individuals take IRA distributions with the intent of paying the money back once the crisis has passed. This can work in some situations. For example, Meyers points out that, once a year, you can borrow from IRAs without taxes and penalties for up to 60 days provided you pay the full amount back to the same IRA.

That's risky, she says, because the same circumstances that drive people to dip into IRAs can keep them from paying back the monies within the 60-day timeframe.

Sometimes consumers intend to reinvest the money the next year or the year after, but even those intentions are flawed, Sokolowski points out. First, there are limits to how much you can invest in one year ($5,000), and any repayment likely will be in place of originally planned investments. Unless finances really turn around and you seek out other retirement savings vehicles in addition to rebuilding the raided IRA, it's challenging to get back to where you would have been had you never taken the distribution.

"It's a lot harder to put the money in than it is to take it out," Sokolowski says. "Once it's out, it's usually out forever."

Digging a bigger hole

Jackson notes that taxes are a risk in another way. Individuals can elect to pay taxes at the time of withdrawal or can wait and pay at tax time. Jackson points out that money problems don't typically go away overnight, and someone who's having trouble making ends meet in November most likely will be having some issues by the time April 15 rolls around as well. If you don't set aside enough of the distribution to pay the income taxes, he cautions, you'll quickly find yourself back in the same situation that forced the IRA withdrawal in the first place.

"I've had clients take money out and not have enough withheld," he says. "Then they prepare their taxes the next year and have to withdraw from the IRA again."

Qualified exceptions

There are some qualified exceptions that can help you avoid tax penalties but not income taxes themselves. These include, but are not limited to, disability, higher education costs, and health-insurance premiums during extended periods of unemployment. First-time home buyers and certain veterans also can withdraw funds without a penalty.

Many financial planners still advise against IRA withdrawals regardless. "In a lot of cases, people are a little too quick to go that route, and it can do serious damage to their retirement accounts," Jackson says. "That's really huge for young people. They think, 'I'm only 32...I'm so far away from retirement.' But it's the early dollars that are so powerful. Boy, they don't know what damage they are doing to themselves."

Substantially equal periodic payments

The IRS does provide one way to take distributions and avoid penalties before an individual turns 59 ½. According to IRS code section 72(t), you can withdraw substantially equal periodic payments for a minimum of five years. Exact payments are determined and calculated according to rules and formulas set out in the code.

Jackson still cautions clients against using this option for short-term needs. The minimum five years of distributions drastically cut into retirement savings unless clients reinvest the money in other vehicles, which they seldom do. "More often than not they spend it," he says.

If you find yourself in such a serious bind that you're considering an IRA withdrawal, talk instead to a credit union financial counselor. The professionals at your credit union can help you manage unforeseen expenses.

Published August 27, 2012

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