Unlike most tax maneuvers, IRAs can lower your PRIOR year’s tax bills by thousands or even tens of thousands of dollars. Sounds great. What’s the catch? The IRS adds a 10% tax penalty on withdrawals taken from IRAs before retirement age on top of any regular taxes owed. Many people are therefore hesitant to tie up their money in tax-sheltered retirement accounts. What happens if they need the money sooner?
Learn the Loopholes
As with anything tax-related, there’s more to the story. In exchange for the tax breaks built into IRAs, the IRS expects that the money remains for its intended purpose: retirement funding. To put teeth behind that expectation, they charge a 10% penalty on taxable IRA income taken before age 59 ½. However, multiple significant loopholes enable the removal of large sums from IRAs without penalty. It is important to consider the fuller picture before writing off these flexible, powerful tax-saving accounts.
Higher Education Exception
One of the most considerable exceptions to the IRA penalty is for money removed to cover higher education expenses. The bills for your or your child’s post-high school education at registered institutions, including BMG and many batei midrash and seminaries, can be paid out of IRA money, penalty-free. This allowance covers required tuition, books, supplies, equipment, and even rent for your son learning in (a registered) kollel! This loophole is pretty big for frum parents in their 40s and 50s. Keep in mind, though, that using this loophole can lower various higher-education tax credits and grants. So, do some research and calculations before trying this approach.
New Homeowner Exception
The “first-time” homebuyers’ exception allows a penalty-free withdrawal of up to $10,000 from IRAs. “First-time” is in quotations because even prior owners can use this loophole if they haven’t owned a primary home in the previous two years. Each spouse can claim this exception for their own IRAs, so the allowance can free up $20,000 if each spouse has a funded account. Also, parents can use IRA funds to help children buy their first home within the same limitations. But, unlike the other IRA loopholes, this is a once-in-a-lifetime exception and caps out at the $20,000 total per couple.
Mazal Tov Exceptions
There’s also a fairly new IRA withdrawal allowance for births. Each parent can remove $5,000 from their (own) IRAs within 12 months of the happy occasion for a total of $10,000 per baby. Since having a baby often raises a family’s bills while lowering their income, accessing some IRA funds can be very useful. The money can be put back later above normal IRA contribution limits. There is no limit to this exception for new children, and the law’s drafter probably didn’t imagine it could be used by some frum couples 5, 10, or 15 times, ka”h!
Medical Exceptions
Other notable exceptions are mainly for misfortunes such as significant unreimbursed medical expenses, health insurance premiums for the unemployed and disability, or death chasv’shalom, when beneficiaries can withdraw inherited IRA funds without penalty. So, we have four categories of loopholes that should allay fears that IRA money will be inaccessible should one be financially strapped down the line.
Tax Savvy Income Shifting with IRAs
Beyond loopholes, however, IRAs are less restrictive than one might think. Even including the 10% penalty, properly planned IRA withdrawals can still be taxed at lower rates than would otherwise apply. Those with heavily fluctuating incomes can use traditional IRAs to shift money from very high tax brackets during boom years to much lower tax brackets in bust years. Even after the 10% penalty, the overall tax bill across the different years can be lowered this way.
Or, in a more sophisticated sense, traditional IRAs can be tax-savvy income hedges for younger people with high incomes. As the good times roll, pre-tax money is deposited, avoiding top tax brackets, hopefully until retirement and expiration of the penalty. But if bad times hit, money can be withdrawn at a similar or even lower tax bracket despite the penalty.
It’s an Option, Not the Option
Anything tax-related is nuanced, so before using any of these tactics, you should run them by your accountant or read up on the topic in detail. Even if a penalty is easily avoided, withdrawals from an IRA (besides principal from a Roth or Roth gains after age 59 ½ plus five years after a Roth account opening) are ordinary taxable income. They can also lower eligibility for various tax credits and social services.
Also, IRA accounts grow and compound tax-deferred, a benefit that can make a massive difference over the years and decades. Raiding retirement accounts is never ideal or straightforward. But sometimes, it’s well worth using IRAs even if the money can’t be placed there until retirement. And my main point is that you probably needn’t fear early IRA withdrawals. A penalty that may not materialize shouldn’t push IRA options off the table.
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