You have to save for retirement. In case any part of that is unclear, I’ll try to spell it out in plainer terms:
YOU HAVE TO SAVE FOR RETIREMENT.
You can make and lose money your entire life, and you’ll probably do exactly that. While you can recoup the thousands of dollars the market might swallow up, you can never win back lost time. Every day that passes without money going into an IRA presents a lost opportunity to make your money grow. These investment accounts rely on a long-term plan - the longer the terms, the better the plan.
Maybe you already know all this stuff. Maybe you started saving for retirement when you were 10 and you’re on track to retire when you’re 30. And maybe, just maybe, even with all of your dutiful planning, you’ll find yourself in a position where you need to pull some money out of an IRA years before you’re ready to retire.
It’s not ideal, but it’s not uncommon. Sometimes an unforeseen expense requires you to spend money you were hoping to save; sometimes you have to an opportunity to put your funds toward a more lucrative endeavor. 99 out of 100 times it isn’t worth it, but we can’t ignore the motivations that lead to early withdrawal.
Most of all, I want you to know which situations avoid the tax and penalty. It’s your money, it’s your retirement, and it’s your job to know what you can do with it.
You can’t use IRA money for any old house purchase, but you get a little leniency if it’s your first venture into homeownership. As a matter of fact, as long as neither you nor your spouse has owned a principal residence in the two years previous, you have access to a penalty-free withdrawal.
Here’s the skinny: you can take money from your IRA, but only up to $10,000. You also have the option to put the money toward a first home for a family member if you already have your own house. After withdrawal, you’ve got 120 to spend the cash before the powers that be start poking around to figure out if you’re behaving properly.
$10,000 sets some clear boundaries as far as who benefits from this penalty-free option. You certainly won’t be using the money to buy a mansion and 10 grand doesn’t cover much of a downpayment. Essentially, this caters most to people who can almost afford a house but need a little boost to get better terms on their mortgage. The option definitely works better for younger folks who have more time to replenish the funds, though dipping into your IRA early in life can set a very dangerous precedent.
I work with self-directed IRAs - one of my favorite investment strategies - and these accounts allow for real estate investing as part of the overall strategy. However, that doesn’t mean you can roll your traditional IRA into a self-directed account just to buy a house. The real estate investments in your portfolio can’t be for personal use; instead they have to go toward things like tax liens and farmland.
While homeownership is one of the approved uses for an early IRA withdrawal, I’d say it’s rarely advisable. In the pinchiest of pinches it can help you improve an offer, but more often than not it’s just a setback for your retirement account. Above all, you have to remember that there’s a limit to how much you can use. If you exceed that $10,000 marker, the IRS will arrive swiftly looking for its penalty money.
Unlike homebuying, you don’t have a spending cap on how much you can take from an IRA to use for qualified university and higher education costs. Since most college students don’t head off to undergrad with loads of money stashed away for retirement, this option primarily targets parents looking to help their kids through school.
Again, using IRA money for tuition, even without a 10% penalty, puts me a little on edge. As you head into your 40s or 50s and face the decision of staying the retirement course or covering your child’s tuition, you have to weigh the pros and cons. On the pro side, you do the kindness of getting your kid a quality education. On the con side - everything else.
While undeniably valuable, a college degree doesn’t translate into immediate revenue. On the other hand, consistently contributing to an IRA over the course of a few decades has absolute value, with a little bit of market volatility mixed in. When all is said and done, if you opt to pay for your kid’s tuition at the expense of your own ability to retire, you could ultimately pass the financial burden on to your offspring. If you become physically unable to work and don’t have the means to retire, the pressure to support lands on the next generation.
That’s a dire version of this story, but it’s not that far of a reach. With a changing economy and more and more Generation Yers and Millenials not starting careers in earnest until their 30s, IRA cash for tuition funds doesn’t look like a particularly even trade. There are infinite variables making each person’s situation unique, but the proposition is still risky at best.
However, the story changes a little when the money isn’t going to a dependent’s education but rather toward your own. Should you, in your 40s, after 10 or 15 years with a company and a good amount of retirement savings, consider taking some of that money and getting a higher degree? I think there’s an argument to be made in favor of doing just that.
This hypothetical comes down to quality of life. If you’ve made good money for a decade or two at a job that doesn’t inspire you to be your best self, I can see using a little retirement cash to shake things up. I expect, however, that a second round of academia will come with more focus and probably less cost than the traditional four-year stint. The ROI on a Master’s Degree that improves your hirability within a chosen field is vastly better than the return that comes after four years of taking general education classes and trying to fulfill the requirements within a fluid undergraduate program.
If you know beyond a shadow of a doubt that reinvesting retirement funds into your education will lead to a better professional outlook and, in the long run, a happier life and better earnings, you could be one of the few who use these IRA rules to your advantage. Alternatively, if you have questions about how the schooling will translate into job opportunities - for yourself or your child - it’s best to leave your IRA alone and figure out another form of financing.
Paying for medical care shouldn’t be in the same category as buying a house or paying for school, but the high cost of an unexpected procedure or hospital stay forces this topic into the conversation.
You obviously don’t have the same control over a debilitating injury as you do house hunting; this type of withdrawal comes from true necessity. Far be it from me to tell you to find another form of financing if a car accident runs up medical bills and takes you out of work for a while. If circumstance forces your hand, you should know how IRA money can be used.
The numbers dictate the terms pretty firmly with medical issues: if you have unreimbursed expenses in excess of 7.5% of your adjusted gross income, you can withdraw that amount from your IRA. So, with an income of $80,000, $10,000 in medical expenses will exceed the threshold and allow you to dip into your account. The limit stays at 7.5%, so you’re looking at $6,000 from your IRA against the $10,000 hospital bill.
When it comes down to it, putting the full $10,000 on credit and subjecting yourself to interest payments that will keep you from making retirement contributions for a long time is worse than stealing from your investment account to soften the blow and ensure you’re back on your feet quickly. Of course, this all goes to show the importance of health insurance and protecting yourself against unpredictable and costly problems.
On the topic of health insurance, your IRA can cover premiums for you and your family during stretches of unemployment. If you lose your job and with it your healthcare, you need to opt into another plan and either pay out of pocket or finance the payments with IRA distributions. Ideally, you have an emergency fund for this type of situation, but using retirement money is preferable to forgoing coverage altogether.
For those of you put in this position, you have my sympathy and prayers. It’s unfortunate that the best-laid plans of financially responsible people can be upended by a physical turn for the worse. These luckless circumstances highlight the need for an emergency fund in addition to your retirement and other investment accounts. When it comes to saving, you really can’t be too careful or prepared.
Odds are you don’t know about this option. Odds are you won’t need to use this option. Odds are I’m still going to explain this option.
Strangely enough, this withdrawal alternative, known as an SEPP program, comes with fewer rules than most others. If you deem it necessary to start taking money from your IRA before you reach 59 ½ years of age, you can establish an annual payout structure. Even if driven by poor reasoning, you can make your case and start emptying your account without the penalty.
While your motivation can be vague, there are some clear guidelines:
● Distributions must last at least five years
● IRS approves distribution amount calculation
● Contributions cease while SEPP program is in place
You also have three options for calculating the amount of each distribution:
● Required Minimum Distribution
Frankly, you have to be in a peculiar financial position to benefit from SEPP. You don’t get to take a big chunk of money out of your IRA all at once, so you aren’t really accessing the funds for a pressing emergency. You also can’t opt out of the program for a minimum of five years, meaning you need to have some sort of long-term plan for the annual payouts. However, since you terminate your ability to contribute to your IRA after initiating the program, that long-term plan includes not adding money to your retirement account.
As for the payout options, they’re calculated based on either the life expectancy of the account holder and a predetermined interest rate (amortization), the age of the account holder and a predetermined interest rate (annuitization), or life expectancy of the account holder and the total account balance (required minimum). Which option you choose depends on your account balance and whatever crazy scheme you have concocted for your funds.
Because you can’t opt in and out of a SEPP program, you need to have a very detailed strategy in place before opening this can of worms. Without a detailed and intelligent plan for your capital, you’re just funneling money out of your IRA while barring yourself from putting any cash back into it.
While all of the options above give me pause, nothing pains my financial advising heart more than watching people hand 10% of a withdrawal amount over to the IRS.
10%. One-tenth of your money gets ripped away, never to be seen again. Money that belonged to you, that should still belong to you, and yet you willingly give it away. You cannot compare the penalty to the amount you receive, because that ignores the nature of investing and putting your dollars to work. When saving for retirement and relying on compound interest, every penny counts; 10% is a whole lot of pennies.
Unfortunately, people get antsy. If you’re 32 and living paycheck to paycheck while putting money away for retirement, it’s a struggle to put the needs of your 65-year-old self over present-day you. Investing takes a good deal of patience and resolve, and those traits are hard to come by when money is tight.
You’ll make your own decisions and live with the consequences, but hopefully a little math will help. If you take $100,000 from your IRA, you lose $10,000 and get $90,000 (we’re ignoring a lot of smaller details for this exercise). While you take much more than you lose, and maybe you have a great scheme cooked up for that $90,000, you still give up an extremely valuable chunk of money. At 32, $10,000 in an IRA, even without additional contributions, will turn into nearly $100,000 by the time you’re in your mid-60s. Throw in a mere $500 a year and you’re looking at something closer to $150,000.
You will live off this money when you retire. These funds will allow you to stop clocking in for work and travel the world, spend time with family or just golf for eight hours a day. Play your cards and your contributions right, and retirement could be the happiest years of your life. Spending it early and throwing 10% of it away could cost you multiple years of happy living.
It’s helpful that the IRS waves the penalty in certain circumstances. For some people, that makes all the difference and can be a literal lifesaver. However, if you have the option to leave your IRA alone, to let that money stay put and grow, that’s the choice you ought to make.