Here’s What Happens When You Take an Early IRA Withdrawal

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An early IRA withdrawal could cost you money in more ways than one. Read on to see why. 

Consistently funding an IRA is a great way to set yourself up for a financially secure retirement. But there may come a point when you decide to take money out of your IRA well ahead of your senior years. If you do so before age 59 1/2, it will be considered an early withdrawal. And from there, a costly penalty could apply.

When you tap your IRA ahead of retirement age

The IRS gives savers who put money into an IRA a tax break on their contributions. If you put $5,000 into an IRA this year, for example, that’s $5,000 of income the IRS won’t tax you on.

Because of this, the IRS wants you to use your IRA balance for its intended purpose — to fund your retirement. And so it doesn’t tend to take kindly to early withdrawals.

As such, if you remove funds from your IRA prior to age 59 1/2, you’ll generally be assessed a 10% penalty on the sum you remove. So for a $10,000 withdrawal, you’re looking at losing $1,000 to a penalty right off the bat. You’ll also be taxed on your withdrawal, though it’s worth noting that taxes apply to all IRA withdrawals, not just early ones.

The only way to not pay taxes on an IRA withdrawal is to keep your money in a Roth IRA. But there, you lose the benefit of tax-free contributions.

Now, there are a few exceptions to that early withdrawal penalty rule. You’re allowed to remove up to $10,000 from an IRA without penalty to buy a home for the first time, for example. And you can also take a penalty-free withdrawal to pay for college. But for the most part, you should expect to be penalized for removing IRA funds before reaching the age of 59 1/2.

It’s not just a penalty you’ll face

Getting hit with a 10% early withdrawal penalty isn’t the only reason to leave your IRA alone until retirement arrives. If you remove funds ahead of retirement, you’ll have that much less money to live on once your career wraps up.

And remember, IRAs don’t typically sit in cash. They get invested to fuel their growth. So come retirement, you’ll be short the sum you withdraw initially plus lost gains.

Over the past 50 years, the stock market has rewarded investors with an average annual 10% return before inflation, as measured by the S&P 500 index. Let’s say your IRA enjoys a similar return, but you remove $10,000 at age 40.

Even if that withdrawal doesn’t subject you to a penalty (say, because you use it to buy a home), if you’re not retiring until age 65, it means you’re missing out on 25 years’ worth of growth. At an average annual 10%, that means you’ll end up with about $108,000 less retirement income than you would’ve had you left that $10,000 in your account.

All told, it’s best to avoid early IRA withdrawals if you can. Doing so could not only mean steering clear of penalties, but getting to retire with less financial stress.

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