You need a financial lift. It is alright; everyone gets blindsided by a large expense at some time or another: your 30-year-old furnace gives up the ghost two weeks into winter, your car’s purring engine is sounding more like a death rattle, or your daughter has requested to have her wedding reception at that exclusive country club. A Self-Directed IRA could be your saving grace.
Yes, you are facing a bill that could easily run into tens of thousands of dollars, and you are not prepared for it. What can you do?
Sometimes, people in desperate straits look to their Self-Directed IRA for a solution. After all, retirement is not for another fifteen years or so. That is plenty of time to replace those funds before you need them.
If this sounds like the perfect answer to your dilemma, you need to take some time to consider all of the imperfections in it. Here are a few reasons why this short-term solution may end up being a long-term headache:
Taxes and penalties
If you are thinking about withdrawing money from a Traditional IRA and you are younger than 59 ½, you will pay a 10% penalty for starters. So the $20,000 that you need for the new heating system will incur a $2,000 penalty!
But you are not finished paying because now the taxes are due on all the funds that helped you save on taxes when you made those contributions. Depending on your tax bracket, you might have to withdraw around $28,000 from your account to net the $20,000 you need, which means your penalty will be even higher.
If you are taking a distribution from your Self-Directed Roth IRA, you will pay a 10% penalty on any earnings from the account if you have not turned 59 ½ or held the account for at least five years, whichever comes later. Remember, this applies only to the earnings on a Self-Directed Roth IRA. Withdrawals from Roth contributions are always penalty-free.
The most painful cost to you
Take the example of a 48-year-old individual who withdraws $28,000 to pay for a $20,000 purchase. Not only will they pay a $2,800 penalty plus taxes, but they will also lose the opportunity for the future growth of those funds.
If that money had remained in the account and been allowed to grow at a modest rate of 5% for the next 20 years, the $28,000 would have grown to a whopping $74,292! They will have missed out on both the power of compounded interest and on a comfortable retirement.
You can avoid the penalty under certain conditions
While there is no way around paying the taxes and losing out on the growth of your funds, you might avoid the 10% penalty under certain circumstances:
· You make the withdrawals on or after the day you turn 59 ½ years of age.
· You are using the money to pay medical insurance premiums during unemployment.
· You are using the Self-Directed IRA funds to pay non-reimbursed medical expenses that exceed 7.5% of your AGI.
· You have become permanently disabled.
· You are a first-time home buyer withdrawing $10,000 or less.
· You are covering qualified higher education expenses.
But it is my money. Why can’t I have it without penalty?
The early withdrawal penalty is meant to discourage retirement account holders from depleting their retirement funds to solve some short-term problem, leaving them dependent on some form of welfare after they reach old age.
After the government enacted the so-called do-it-yourself retirement system, the Self-Directed IRA early withdrawal fee was attached to encourage savers to stick with the plan and reap the rewards of many years of compound interest and growth in their portfolios. For all those reasons—a hefty penalty, taxes due, and the lost opportunity to accumulate capital—it is practically always a bad idea to cash in your Self-Directed IRA funds.
At American IRA, we believe that Self-Directed IRAs are the best vehicles for growing your retirement account. And we have the experience to handle your transactions, no matter which direction you choose to go with it.