The Pros and Cons of an Early Withdrawal from Your Roth IRA

You can withdraw your contributions from your Roth IRA at any time and for any reason, but that does not mean it is a good idea. There are a number of reasons why you might want to think twice before taking an early withdrawal from a Roth IRA.

Pro: You Can Withdraw Contributions for Free

A Roth IRA offers a unique tool for accessing money in a pinch. You can withdraw contributions at any age, for any reason, without owing any income taxes or penalties. The reason: You made your Roth IRA contributions with after-tax money, so you have already paid the taxes on it.

Contributions are the money you deposited into your Roth account. Your total Roth IRA balance includes both contributions and earnings—the interest and dividends your contributions have accumulated since they were invested.

While you can withdraw your contributions tax-free and penalty-free at any time, earnings work differently. If you withdraw earnings, you may owe taxes and penalties. It depends on your age, how long you have held the account, and how you plan to use the money.

Pro: There are Exceptions to Early-Withdrawal Penalties

If you wait until you’re at least 59½ and your account is at least five years old (the five-year rule), you can withdraw contributions and earnings without owing taxes or penalties.

But what happens if you need the money sooner? You may qualify for an exception to the early withdrawal penalty. You can avoid the penalty if you use the money:

• For a first-time home purchase (subject to a $10,000 lifetime limit)
• To pay for qualified education expenses
• For unreimbursed medical expenses (greater than 10% of adjusted gross income (AGI) in 2021)
• As a series of “substantially equal periodic payments”
• To pay back taxes because of an IRS levy placed against the IRA
• Because you have a permanent disability
• Because you pass away (and your beneficiary or estate takes the distribution)

Pro: You Can Use Your Roth IRA as an Emergency Fund

Conventional wisdom suggests that you should maintain an emergency fund of three to six months of living expenses. But that’s a tall order for many people.

For that reason, more people are reaching into their retirement accounts—Roth IRAs, traditional IRAs, and 401(k) plans—when an emergency hits. All of these retirement funds can provide a pool of cash to tap for emergencies and major expenses, such as buying a home or starting a business.

The advantage of the Roth is that you may be able to take the money out tax-free. And if you don’t have any emergencies, you can just leave it alone to continue growing.

Pro: You Can Avoid Taking a Loan

If you need money, an early withdrawal can also help you avoid borrowing money from a lender. Loans usually have high interest rates, which can make borrowing expensive. This is particularly true if you have bad credit and don’t have access to traditional lending options.

Still, that does not mean it is free to take money out of your retirement account. You could be on the hook for taxes and penalties that could end up costing more than a loan. So be sure to run the numbers before choosing between a loan and an early withdrawal.

Con: You May Owe Taxes and Penalties

You could be hit with a 10% early withdrawal penalty and income taxes if you withdraw any earnings from your Roth IRA.

You may be able to escape both the taxes and the penalty if the account is at least five years old and you are 59½, or if you meet a few other specifications. Here’s a quick rundown:

If you’ve met the five-year rule and you are:

• Under 59½: Withdrawals of earnings are subject to taxes and penalties. You may be able to avoid both if you use the money for a first-time home purchase, or if you have a permanent disability or pass away (and your beneficiary takes the distribution).
• Age 59½ and older: No taxes or penalties.

If you haven’t met the five-year rule and you are:

• Under 59½: Withdrawals of earnings are subject to taxes and penalties. You may be able to avoid the penalty (but not the taxes) if you use the money for a first-time home purchase, qualified education expenses, or unreimbursed medical expenses, or if you have a permanent disability or pass away (and your beneficiary takes the distribution).
• Age 59 ½ and older: Withdrawals of earnings are subject to taxes, but not penalties. As noted above, if you can wait the five years, you avoid both.

Con: You Can’t Repay the Money

In general, you can borrow up to $50,000 (or 50% of your vested balance) from a 401(k) and repay it within five years. While that puts you a little behind on your retirement savings, the money still ends up back in the account.

IRAs work differently. You cannot borrow money long term from an IRA. Instead, any money you take out is a withdrawal—not a loan. You have 60 days to redeposit the money into the same IRA or another qualified account. After that, it is considered a permanent withdrawal—with tax and penalty consequences.

Con: You Miss out on Future Earnings

Since you cannot repay the money, you will miss out on future earnings, and that can take a huge bite out of your retirement savings. This is the biggest drawback to taking an early withdrawal.

The value of a Roth IRA and other tax-advantaged retirement accounts is the power of compounding interest. If you withdraw money from your Roth IRA early, that money never compounds because it won’t be there. Plus, the interest you would have earned had you left the money alone will never earn interest either.

Here’s a quick example. Let’s assume you invested $5,000 every year for 20 years and earned an average 8% annual rate of return. After those 20 years, your account would have grown to about $247,000. If you never invested another dime and just let your balance compound for the next 20 years, you would be sitting on more than $1.15 million.

But what would happen if you had taken just one $20,000 early withdrawal from your Roth IRA after that first 20 years? In the end, your account would have grown to less than $1.06 million. While that’s nothing to sneeze at, taking that $20,000 early cost you around $93,000 in future earnings from compounding interest.

The Bottom Line

When you have no other option, it may be comforting to know you can take an early withdrawal from your Roth IRA. But it may be a last resort. Crunch the numbers and speak with a qualified financial planner or investment advisor if you have questions.