Scared to Save on Taxes? Your IRA Account  Isn’t a Jail

An IRA account allows you to save money for retirement with tax free growth. But what if you need the money before retirement age? The IRS adds a 10% tax penalty on withdrawals taken from IRAs before retirement age, assessed on top of any regular taxes owed. But don’t worry; there is no need to panic! Are IRA’s really so tightly restricted? There is another perspective on IRA’s that you may be missing. 

You Want a Tax Break? Lock it Up.

The rigid tax code often takes back whenever it gives. In exchange for the tax breaks built into IRAs, the IRS expects that the money remain there for its intended purpose- retirement funding. To put teeth behind that expectation, they charge a 10% penalty on taxable IRA income taken before age 59.5. (The tax-geeks designing the laws seem to enjoy adding these quirks, like the need to precisely calculate half years. There’s also a 5 year rule for Roth IRAs which can get confusing too.) However, multiple loopholes enable the removal of large sums from IRAs without penalty. It is important to consider the fuller picture, including some very common penalty loopholes, before writing off these flexible, tax-saving accounts.  

Higher Education Exception

One of the most considerable penalty 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 meidrash 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! For frum parents in their 40’s and 50’s, this loophole is a pretty big one, but it can offset various higher education tax credits and also lower grant eligibility. Be sure to do your careful research before trying this as it may well not be worth losing the credits and grants despite the penalty exception.  

New Homeowner Exception 

The less complicated “first- time” home buyers’ exception allows them to a withdrawal of up to $10,000 from IRAs, penalty-free. “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 they each have a funded accounts. Also, parents can use IRA funds to help children buy their first home, within the same limitations. This flexibility can be beneficial to those who want to assist their married children with a milestone event but don’t have any free cash lying around. Nevertheless, this is a once-in-a-lifetime exception and caps out at just the $20,000 total per couple. 

Good News/Bad News Exceptions

There’s also a brand-new IRA withdrawal allowance for births and/or adoptions. Each parent can remove $5,000 from their (own) IRAs within twelve months of the happy occasion (for a total of $10,00 per baby), to be used for any purpose. Since having a baby often raises a family’s bills while lowering their income, having access to some IRA funds can be very useful. (The money can be put back at a later time above normal IRA contribution limits, though the details of how that works are still unclear.) There is no limit on this exception for new children- (the drafter of this law probably didn’t imagine it could be used by some frum couples 15 times ka”h!) Other exceptions are mainly for misfortunes such as un-reimbursed medical expenses, disability, or death chas v’shalom, when beneficiaries can withdraw inherited IRA funds without penalty.

The Whole IRA Lock is Loose

 Beyond loopholes, however, IRAs, in general, are less restrictive than one might think. Roth IRAs, funded with previously taxed income, allow the withdrawal of all principal at any time with no penalty or tax. (Regardless of age, tax is owed on Roth GAINS if withdrawn before its owner has had a Roth account for 5 years.) And 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 in 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 the penalty expires., 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 also Roth gains after age 59.5 plus 5 years after a Roth account opening,) is ordinary taxable income and 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 it to use IRAs even if the money can’t be placed there until retirement. A penalty that may not even materialize shouldn’t wipe valuable IRA options off the table.


Want to dig deeper?

Try these related articles

Individual Retirement Account (IRA) Myth-busting

Earn Billions Tax Free: Unlocking the Power of Roth IRAs

How to Open and Use Your Own IRA

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