Think Hard Before Taking an Early IRA Withdrawal (article)

To deal with financial pressures stemming from the recent economic recession, many people who, in better times, saved for retirement have chosen to make early withdrawals from their IRAs as a source of needed cash. While that is a tempting short-term solution to immediate problems, taking early IRA withdrawals can cause more problems than it solves.

Withdrawing money from a traditional IRA or a Roth IRA before you reach age 59½ subjects you to an income tax obligation and a 10% penalty on the amount you withdraw – a huge price to pay for using your own money. Worse, an early withdrawal from a “Simple” IRA created in the past two years causes the penalty to increase to a whopping 25% of the amount withdrawn.

Exceptions to the penalty may exist for early withdrawals of IRA contributions (deposited at least five tax years ago) in order to pay for medical expenses in excess of 7.5% of adjusted gross income, medical insurance premiums, disability, a first-time home purchase, college expenses, IRS seizure of IRA funds to pay taxes, and a few other uses. However, the rules governing exceptions are complicated and should be researched before making an early IRA withdrawal.

In addition, all withdrawals (early or not) from traditional IRAs are taxable, meaning that, except in the case of a qualified rollover, the owner pays income taxes on all the money taken out of the account. Further, income taxes can be owed on Roth IRA early withdrawals if they are deemed to be “unqualified” distributions. (Such distributions are beyond the scope if this article.) By the time you factor in the early withdrawal penalty, federal income taxes and state income taxes, you could be left with only about half of the amount you withdrew from the IRA. This waste of your hard-earned retirement funds can, in many cases, be avoided; keep reading to learn how.

Under Arizona law, IRA funds enjoy strong protection, provided those funds remain in the IRA. Even in bankruptcy, IRA funds are generally “exempt” from being seized to pay creditor claims, thanks to Arizona's 1990 Herrscher decision. (For more on exempt assets, see “Exempt Assets in Chapter 7 Bankruptcy.”) Further, creditors cannot normally obtain IRA funds belonging to Arizona residents even if they have not sought bankruptcy protection. While there can be exceptions to any law or case, we have found that almost all IRA owners in Arizona are protected … as long as they do not lose that protection by withdrawing their IRA money.

If you are facing the loss of your home or trying to stave off bankruptcy, withdrawing IRA funds in order to meet pressing obligations may simply delay the inevitable and prolong your financial pain. We see many clients who seek an attorney’s help only after they have already spent their IRA and other funds in a desperate attempt to avoid bankruptcy – sometimes to the point that they no longer have enough money to pay an attorney to file their bankruptcy. In many cases, the client could have kept their IRA funds and started to rebuild their finances with a timely bankruptcy filing, but fear and misconceptions about their options cause them to exhaust their IRA and make other bad decisions.

Don’t fall for the trap of trying to save your home at all costs. Sometimes, allowing a foreclosure or even hastening one is a homeowner’s best option. Doing so can get you out of a bad mortgage and conserve money that can be better used elsewhere. In Arizona and some other states, many homeowners are protected from post-foreclosure collections by “anti-deficiency” statutes. Further, while the forgiveness of debt by a lender can, in some cases, result in a tax liability for the ex-homeowner, we often find that there is no additional income tax owed due to a foreclosure or loan modification. The result is that many homeowners can simply walk away from a bad loan with few consequences other than a temporary “ding” to their credit report.

In summary, think twice before taking an early withdrawal of money from your IRA. You worked hard to save your IRA money, which enjoys strong protection against creditors. Don’t lose that hard-earned money and protection for a temporary “fix” to a financial problem without getting professional advice beforehand.

If you are in financial difficulty now or think you might be in the future, see a qualified bankruptcy attorney to learn your legal rights and how to best protect yourself, your family and your assets. A little planning can save you money and give you the comfort of having a plan to deal with the future.

J. Phillip Glasscock, P.C., is a debt relief agency. We provide assistance with respect to credit defaults, mortgage foreclosures, eviction proceedings, excessive debt, debt collection pressure or inability to pay any consumer debt. We help people file for bankruptcy relief under the Bankruptcy Code.