Cashing Out Traditional IRA Early
Cashing out a traditional individual retirement account (IRA) can be expensive. The Internal Revenue Service lets you save money in an IRA without having to pay taxes on it until you withdraw it, based on your promise to leave it in there until you turn 59 1/2 years old. Withdrawing early subjects you to taxes and penalties, unless you’re taking the money out for an IRS-approved reason.
Tax and Penalty
Early withdrawals from a traditional IRA are subject to federal income tax and an extra 10% penalty. For instance, if you pay taxes in the 25% bracket and cash out a $25,000 IRA account, it will cost you $8,750, leaving you with net proceeds of $16,250. The $8,750 consists of 25% tax, which is $6,250, and the 10% penalty, which is $2,500. Your IRA custodian usually automatically withholds 20% of your withdrawal and sends it directly to the IRS. You’ll need to pay any extra that isn’t withheld for you. In addition, you might also have to pay state income tax on the money you take out—so don’t forget to subtract that from your net proceeds amount.
The IRS lets you cash out some or all of your IRA without penalty in special circumstances, although you will still have to pay taxes on the withdrawal. These circumstances include using the IRA to pay for higher education expenses, to pay medical expenses that exceed 10% of your adjusted gross income, or to pay for medical insurance while you are unemployed. You can also take out money to pay taxes, potentially saving you from an IRS tax lien that could show up when lenders perform a credit check on you. The IRS even lets you cash out up to $10,000 penalty free – but not tax free – to purchase or build a home if you are a first-time home buyer.
The Opportunity Cost Penalty
Whether or not you pay the 10% penalty, there’s an opportunity cost to pulling money out of your IRA. Cashing out your IRA means that money won’t be growing and set aside for use later during retirement. A $20,000 IRA balance growing at 8% per year generates $1,600 in income a year, not taking into account any compounding that makes it grow even faster. If you withdraw and don’t replace the money, you lose that potential income, which can be a major loss to your retirement plans.
Cash Out vs. Rollover
While cashing out an IRA is a taxable event, pulling out the money to transfer it to another retirement account isn’t, as long as you follow the IRS’s rules. If you do a direct trustee-to-trustee rollover, the money gets sent right from your first IRA company to your new one with no tax issues. However, when you receive the money directly after cashing out an IRA, you have to deposit it into a new IRA within 60 days to avoid related penalties and expenses.
About the Author
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. Lander holds a Bachelor of Arts in political science from Columbia University.