In general, cashing out an IRA is a bad idea. That being said, and I think I’m contractually obligated to mention that as a personal finance blogger, there are times when you simply have no choice. When faced with certain decisions, you might have to make a few that you know are bad for the long term but necessary for the short term. To cash out an IRA may be one of them.
So, if you are faced with such a decision, I think it’s important that we review how you can cash out an IRA and avoid the 10% penalty. It will not be possible for you to avoid paying taxes on the withdrawal, since you never paid taxes when you contributed, but we can at least try to avoid the ugliness of the 10% penalty.
Qualified Educational Expenses
As long as you pay for “qualified educational expenses” for you, your spouse, your children, or your grandchildren, it’s safe. It needs to be a qualified institution, which means the IRS has to approve, and it can be public or private, as long as it’s accredited. Qualified educational expenses include tuition, fees, bucks, supplies, and anything else that falls under the category of requirement equipment. If you’re enrolled at least half-time, room and board count too.
First Time Home
You can use up to $10,000 of your IRA towards the purchase of your first home. If you are married and you are both first time homebuyers, you can withdraw
$10,000 each for a total of $20,000. The slick thing about first time homebuyers is that the IRS considers you a first time homebuyer if you haven’t owned a home in the previous two years, which is probably a lot looser than you thought. Also, you can withdraw the funds to help your children, grandchildren, or parents in addition to yourself (and spouse).
The first two rules probably don’t fall into the category of “you have no choice.” But the “hardship widthdrawal” rules do and fortunately for you, the rules are more lax when it comes to an IRA. With a 401(k), hardship rules are a little stricter because you’re still dealing with an employer. With an IRA, the government is still getting their tax revenue so it’s a little less stringent.
So what counts as a hardship? Here are some common ones :
- If you use the funds to pay for un-reimbursed medical expenses that are greater than 7.5% of your AGI,
- If you become disabled before 59.5,
- If you agree to take equal distributions from your IRA over your life expectancy, according to the official IRS calculation method.
So, if you are going to cash out an IRA, try to make sure it’s for one of the three categorical reasons I listed above or the IRS is going to take yet another bite. If you’re withdrawing it because of hardship, don’t let the IRS make it even harder!