The temptation to pull money out of your retirement accounts is always there regardless of whether you are doing well with your conventional IRA or you are a hardcore self-directed IRA enthusiast. Even then, this is a bad move for a majority of the self-directed IRA investors.
This is because the opportunity costs and penalties from the foregone preferential tax treatment in future years can be severe. A survey of investors who are experienced in E-Trade who pulled money out of retirement account before the retirement age revealed that it was the biggest mistake people make with their retirement accounts.
The survey results indicate that younger investors were more likely to make this mistake. According to the report, 34% of the millennials reported who responded to the questionnaire indicated that they had made retirement withdrawals. Let us examine reasons why pulling money out is a serious mistake that you must avoid on your retirement accounts:
Tax penalties for early withdrawals from self-directed IRAs and other retirement accounts
Making withdrawals from your retirement accounts can be a costly move. This is because, apart from defined hardship provisions that are spelt out by the law, withdrawals from SEP IRA, traditional IRA, 401 (k) or SIMPLE IRA plan before you attain the age of 59½ automatically attracts excise tax penalty of 10%. Further, the penalty for SIMPLE IRA may be as much as 20 percent should you withdraw within the first three years. Even then, the penalty will not apply in cases where you separated from your employer and are above 55 years.
This penalty is usually stacked on income tax at the highest marginal rate. Assets that are pulled out of IRAs as well as other retirement accounts are not eligible for lower long-term capital gains rates. As such, you end up paying full boat ordinary income tax on those amounts. In addition, if your state levies tax on retirement accounts, you will responsible for state income taxes
The Hidden Cost of Tapping your self-directed IRA too soon
Besides taxation penalties, the opportunity cost is perhaps the real damage that is associated with pulling money out of your self-directed IRA soon. Consider a scenario where a 40-year-oldself-directed IRA pulls USD 10,000 from the retirement account for another account to put it into another area of priority.
Although you are eligible for hardship withdrawal, you have to give up the amount that the money would have generated when you attain your retirement. If your average annual return is 7 percent, which is quite conservative as many clients are entitled to much more, the money would grow to up to $76,000 when you get to 70.
It is important to keep in mind that the damage that you do to potential retirement savings in the case of an early withdrawal cannot be reversed. Thus, your contributions are limited even where you want to invest a section the following year. For IRAs that are compound tax free like Roth IRAs, you will be limited to an annual contribution of $5,500 for every year until you get to age 50 where you can add a $1,000 contribution. Even then, the ability to remove your contribution to traditional IRAs is limited by your income just like your ability to contribute to a Roth IRA.
Therefore, no matter the amount you will have the following year, it is impossible to get the year back.
Self-Directed IRA investors should take the long view
The best long term approach is refraining from pulling money out of your self-directed IRAaccounts at least until the 10 percent penalty provision expires. In the event that you need early retirement, you can take advantage of early retirement penalty exception for IRS as per section 72(t) of the Internal Revenue Code. This code allows annuitization of IRA penalty free as long as you do so with a series of significantly equal periodic payments against your life expectancy or joint life expectancy in the case of you and your spouse.
If you are not sure about how to make the most of your self-directed retirement plans, get it touch with Self Directed Plans, LLC a leading retirement expert serving self-directed account holders.