The Do's and Don'ts of IRA Withdrawals

Editor's note: As a special feature for April, TheStreet.com is offering a seven-part series on maximizing your IRA. This installment is Part 3. Click here for Part 1, Part 2, Part 4, Part 5, Part 6 and Part 7.

There are substantial penalties to be paid for making withdrawals from an IRA before you reach age 59 1/2 or, in the case of a Roth IRA, if withdrawals occur within the first five years of a contribution. So investors need to make every effort to plan ahead and should have a reserve fund established for emergencies.

Early withdrawals from traditional IRAs are subject to a 10% penalty in addition to the payment of income taxes on the amount withdrawn. There is a loophole that lets you avoid a penalty if you withdraw money from an IRA and pay it back within 60 days. However, no investor should rely on this form of short-term financing.

There are eight legitimate exceptions that will avoid the 10% penalty:

1. The IRA owner becomes disabled.
2. The IRA owner dies.
3. The IRA owner elects to take "substantially equal periodic payments" from his IRA over his remaining life expectancy.
4. Withdrawals are used to pay for medical expenses exceeding 7.5% of adjusted gross income.
5. Withdrawals are used to pay medical insurance premiums after the IRA owner has received unemployment compensation for 12 weeks.
6. Withdrawals are used to make a first-time home purchase. (This exception is subject to a lifetime maximum of $10,000.)
7. Withdrawals are used to pay higher education expenses for the IRA owner or other eligible family members.
8. Withdrawals are used to pay back taxes because of an IRS levy.

I should emphasize that, while these exceptions will avoid penalties, they are still to be avoided if at all possible (especially No. 2). When withdrawals are made before retirement, your tax-deferred compounding is halted, and there is no way to recover that loss.

At the other end of the life cycle, owners of traditional IRAs are subject to penalties if they do not withdraw a sufficient amount each year starting at age 70 1/2. These distributions must begin by April 1 following the year that the age trigger is reached. Otherwise, a 50% extra tax on the amount not distributed will be assessed.