10 Reasons Why People Cash Out IRAs Early

There are few things more frustrating than watching your retirement funds shrivel up with a falling stock market. From October 2007 to March 2009, the Dow Jones industrial average dropped from more than 14,000 to 6,600, halving the value of many IRAs [source: Google Finance].

Some investors refuse to watch their retirement savings disappear, so they cash in their IRAs to make more profitable investments. But in a down market, that's a big gamble.

If you pull money from a traditional IRA before 59 ½, you will pay income tax on the full amount, plus a 10 percent early withdrawal penalty. So if you have $100,000 in an IRA and you are in the 25 percent tax bracket, you will lose $25,000 to taxes and $10,000 more to penalties. You would have to make one heck of a brilliant investment to recoup those losses.

If you pulled money from a Roth IRA, there's more wiggle room. Since you pay income tax on contributions to a Roth IRA, you can withdraw the amount you have invested — before any earnings — tax-free at any time. If you want to tap the earnings, though, you need to wait at least five years from the time you made your first contribution to the Roth IRA. Otherwise, the earnings will be taxed as income. Both earnings and contributions taken before age 59 ½ will incur the 10 percent early withdrawal penalty, unless you meet some of the exceptions we'll discuss later. Unfortunately, a down market is not one of them.

For people with substantial amounts of expensive debt — such as large balances on high-interest credit cards — that pile of IRA cash might look like an attractive way to quickly pay off debt. But if you are younger than 59 ½, personal finance experts say don't do it because of those serious downsides we just discussed.

Of course, there are significant costs to carrying a large amount of credit card debt. In January 2013, the average interest rate on all credit cards was 14.96 percent [source: Dilworth]. Will your IRA grow faster than 14.96 percent this year? Probably not, but remember the penalties. Between taxes and early withdrawal penalties, you could lose 33 percent or more from your IRA just from cashing in early [source: Updegrave].

A more measured approach is to cut back on your IRA contributions and use that money to pay down credit card debt [source: Orman]. That way you can get rid of your debt sooner without cracking open that precious retirement nest egg.

There's good news for anyone who wants to retire early and withdraw IRA funds penalty-free before age 59 ½. The method is called substantially equal periodic payments or SEPP. According to IRS rule 72(t) — that's the rule that establishes the 10 percent early withdrawal penalty — you can avoid the 10 percent hit if you withdraw a portion of your money from your IRA in a series of carefully calculated annual payments. The SEPP method is good for both traditional and Roth IRAs [source: IRS].

The IRS offers three acceptable methods for calculating your SEPP. Each method is based on your current age, your life expectancy and something called the Applicable Federal Mid-term Rate, a baseline interest rate established by the IRS for tax purposes. You can find a detailed explanation of each calculation method on the IRS Web site. In short, these calculation methods tell you exactly how much money you can withdraw from your IRA each year without incurring a penalty.

The trick with the SEPP method is that you must withdraw the predetermined amount exactly — not a penny more or less — and you must make annual withdrawals for at least five years or until you turn 59 ½, whichever comes last [source: IRS]. Any deviation from this method will trigger a retroactive 10 percent penalty on all the money you have withdrawn [source: Money Magazine]. The upside is that you can launch your retirement at 50 (or younger) and access some of that IRA cash early.

Need cash fast? You probably don't want to acquire it from your high-interest credit cards. Hitting up family and friends isn't always the best method either. Loans can take a month or longer to come through — if you're approved. IRA money, however, can be accessed in just a few weeks. It's no wonder the temptation is so great to cash out.

But while the temptation is great, so are the costs we keep mentioning: income tax, early withdrawal penalties, or both. The whole point of an IRA is to put money away for retirement and let it grow. With a traditional IRA, you get the added benefit of tax-deductible contributions. With a Roth IRA, you pay taxes upfront, but your retirement investments grow tax-free. IRA investing should be viewed as a long-term saving strategy, not as a short-term cash fix.

If you are really desperate for cash, it makes more sense to sell some liquid assets — a car, boat or jewelry — rather than dip into your retirement savings.

The Great Recession of 2007 to 2009 struck a crushing blow to many Americans' finances. People who face insurmountable financial problems are often advised to think about filing bankruptcy. Considered a last resort, bankruptcy makes a mess of a person's credit rating, and depending on the type of bankruptcy filed, all of the person's assets may be sold to pay the debt. From 2009 to 2010, bankruptcy terminations rose 110 percent in Nevada, 57.7 percent in central California and 43.2 percent in South Florida [source: U.S. Courts].

You might be tempted to do anything to avoid bankruptcy, including cashing in your IRA. But there's good news! Thanks to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, up to $1 million of IRA assets are protected from creditors during a bankruptcy [source: Greene]. Even better, if you roll over 401(k) assets into an IRA, 100 percent of that money is immune from bankruptcy, even if it's more than $1 million [source: TIAA-CREF].

It's a terrible thought, but what if you or your spouse were in a serious car accident and could no longer work? Even if you qualify for cash assistance under Medicaid's Supplemental Security Income (SSI) program, it still might not be enough to cover your expenses. Once you've depleted your other savings, you might choose to start withdrawing cash from your IRA. But what if you're younger than 59 ½? Won't the IRS hit you with a 10 percent early withdrawal penalty?

Thankfully, no. Disability is one of the official exceptions to the early withdrawal rule. According to the IRS, if you become disabled before age 59 ½, the 10 percent penalty does not apply to early withdrawals from either traditional or Roth IRAs. To qualify for the exception, though, you will need a note from a physician confirming that your disability prevents you from doing any "substantially gainful activity" and that your condition is permanent [source: IRS].

To qualify for any of the official exceptions to the 10 percent penalty, you need to file form 5329, "Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts," along with your 1040 tax return. The most important entry is Line 2, where you are prompted to enter the "appropriate exception number," one through 12, for your early withdrawal. The list of exception numbers is found in the instructions for form 5329. Hold onto all paperwork, doctors' notes and receipts, because the IRS could always call you in for an audit. Gulp.

Buying a home is the culmination of the American dream, but the costs can add up. Even if you can scrape together 20 percent to cover the down payment, there are closing costs, mortgage insurance and other fees that can add thousands to your bill. It's tempting to tap your IRA in order to close on a dream home. But is that a good idea?

First, the good news. The IRS waives the 10 percent early withdrawal penalty for first-time homebuyers. That means you can withdraw up to $10,000 from either a traditional or Roth IRA before age 59 ½ without the extra 10 percent tax. Even better, your spouse can withdraw the same amount penalty-free [source: IRS]. The IRS is very generous with its definition of a "first-time" homebuyer. As long as you haven't owned a home in the past two years, you're good [source: IRS].

Now, the fine print. You need to use that $10,000 to pay for the buying, building or rebuilding of a home within 120 days of withdrawing the funds, or else you will be smacked with the 10 percent penalty. But if the 120-day deadline is looming, and your home purchase or construction was canceled or delayed, you can roll the funds back into your IRA penalty-free [source: IRS].

And remember, just because you avoid the penalty doesn't mean you avoid taxes entirely. You still have to follow the income tax rules for early withdrawal of the two types of IRAs.

The cost of college in America has skyrocketed over the past decade, with in-state tuition at four-year public colleges and universities increasing 104 percent, and tuition at private institutions jumping 60 percent. And that's not talking about the other college costs. The average sticker price of attending a private American college or university — tuition, room, board, books — was $43,289 for the 2012-13 school year [source: Clark].

Sure, IRAs are technically earmarked for retirement, but the IRS gives you a break to help pay for higher education expenses. Like the first-time homebuyer exception, the IRS waives the 10 percent early withdrawal penalty if you take out the money to cover any and all college expenses, including tuition, books, fees, and room and board if the student is enrolled at least half-time [source: IRS]. The higher-education exception is good for you, your spouse, your children and even your grandchildren.

Again, while the IRS waives the early withdrawal penalty, the normal IRA tax rules still apply.

Here's a morbid scenario. What if you save up a sizable nest egg in your IRA, but die in a tragic accident before you reach the magic age of 59 ½? It seems only fair that your spouse, children, ferret or other legal heirs could cash in your IRA. But will they have to pay income tax, or an early withdrawal penalty, if they want to collect their inheritance?

The bad news is that you're dead, but the good news is that your heirs are exempt from the 10 percent early withdrawal penalty [source: IRS]. As usual, there is some fine print when it comes to taxes. If you leave a traditional IRA to your heirs, they will most likely pay income tax on any withdrawals from the account, unless a portion of your contributions to the traditional IRA were non-tax-deductible. But if all of your contributions were pre-tax — which is common — then all distributions, even to your heirs, are taxed as income.

If you leave a Roth IRA to your heirs, they won't have to pay income tax on withdrawals unless the account is less than 5 years old. If you made the first contribution to the account less than five years before you pass on, then your heirs will have to pay income tax on any earnings or gains [source: IRS]. Also, if your spouse wants to roll your retirement funds into his or her own IRA, he or she will have to pay income tax on the rollover.

You can withdraw money early from both a traditional and a Roth IRA without a 10 percent penalty if you're paying medical expenses that aren't covered by insurance. The exception applies to unreimbursed medical expenses for your spouse, your dependents or yourself.

There's a limit on this exception, though. To avoid the 10 percent penalty, the amount you withdraw to cover medical expenses cannot exceed the total cost of the medical expenses minus 7.5 percent of your adjusted gross income for the same tax year [source: IRS]. In other words, the IRS thinks that it's reasonable that you spend at least 7.5 percent of your salary on unreimbursed medical expenses before tapping into an IRA.

The IRS offers an additional exception for folks who are paying for their own medical insurance while unemployed. If you lose your job and collect state or federal unemployment compensation for at least 12 consecutive weeks, you can use IRA money to cover your medical insurance premiums penalty-free. Again, you may owe income tax on those distributions, but you are exempt from the 10 percent early withdrawal penalty.

For lots more information on IRAs, 401(k)s and the IRS, check out the links on the next page.