In my last post you learned why it makes sense to pay cash for major purchases like a car or home improvement. When you consider your interest rate and the after tax return you would have to make on your investments it just doesn’t make sense to take on debt if you can avoid it.
IRAs change everything
Sometimes clients ask me if they should take money from an IRA or other tax-deferred retirement account like a 401k to pay for a major purchase such as a car or home improvement or even another investment. If you read my last post, you know that I am not a fan of taking on debt if you can afford to avoid it. However, IRAs change everything.
With very few exceptions, distributions from IRAs and tax deferred retirement plans are taxable. And in some cases there may be a 10% early withdrawal penalty added to the taxes you owe. A $15,000 withdrawal increases your taxable income by that same amount. If you are in the 33% combined Federal and state income tax bracket, your tax bill on this distribution would be $5,000. To net out $15,000 you will need to take $22,388 from your IRA. The distribution may also be subject to a 10% penalty. This means you need a total distribution of almost $25,000 to net out $15,000 after taxes and penalties.
In English: any money you take out of an IRA raises your tax bill for the year – a lot.
In addition to the extra tax you pay, that extra income could have unintended consequences as well. Following is a brief list of things that can happen if your income spikes one year.
- College financial aid and scholarships can be reduced or eliminated
- Education related tax credits like the American Opportunity Tax Credit and Lifetime Learning credit could disappear
- You could become ineligible to contribute to tax deductible IRAs and/or Roth IRAs
- Social Security benefits could be more heavily taxed
- Medicare premiums can go up
In short, any tax or government related benefit you receive that is tied to your income could be affected by your IRA distribution.
Penalties for early withdrawals
As I mentioned above, the IRS may assess a 10% penalty for the early withdrawal if you are under the age of 59 ½. When it’s all said and done, you may lose up to half of your distribution amount to Federal and state income taxes, IRS penalties and other costs.
IRAs and retirement accounts are just that – retirement accounts. Treat them as special assets only to be used to produce retirement income. Resist the urge to treat them as deferred spending accounts and you (and your retirement) will be better off for it.
Required Disclosure: Please note that individual situations will vary and this is not intended to be a substitute for specific investment or tax advice. Please seek personalized advice from a qualified professional.