Are IRAs Liquid Assets? What to Know About Withdrawing

An Individual Retirement Account (IRA) represents a personal savings plan with tax advantages designed to help individuals save for retirement. These accounts offer benefits that encourage long-term growth, either by allowing tax-deductible contributions or tax-free withdrawals in retirement, depending on the IRA type. Understanding the nature of these accounts, particularly their accessibility, is important for financial planning.

Defining IRA Liquidity

A liquid asset refers to cash or an investment that can be converted into cash quickly and without a significant loss in value. Examples of highly liquid assets include cash in a checking or savings account, or publicly traded stocks and bonds that can be sold rapidly on an active market. Such assets are readily available to meet immediate financial needs.

Individual Retirement Accounts are generally not considered liquid assets. Their primary purpose is long-term retirement savings. The tax advantages associated with IRAs come with restrictions on early access, limiting their immediate convertibility to cash.

Penalties and Taxes for Early Access

Accessing funds from an IRA before reaching age 59½ incurs both income taxes and an additional penalty. For most Traditional IRA withdrawals, the amount is subject to ordinary income tax rates, as contributions were made on a pre-tax basis. This means the withdrawal is added to your taxable income for the year.

In addition to income tax, a 10% additional tax, commonly referred to as an early withdrawal penalty, applies to distributions taken before age 59½. This penalty applies to the taxable portion of the withdrawal. For instance, withdrawing $10,000 from a Traditional IRA without an exception would mean $1,000 in penalty alone, on top of the income tax.

For Roth IRAs, contributions can be withdrawn tax-free and penalty-free at any time, as they were made with after-tax dollars. However, if earnings are withdrawn before age 59½ or before the account has been open for five years, they may be subject to both income tax and the 10% additional tax, unless an exception applies. The IRS outlines these rules and exceptions.

Circumstances for Penalty-Free Withdrawals

There are specific situations where the 10% additional tax on early IRA withdrawals may be waived, even if the account holder is under age 59½.

First-Time Home Purchase

One common exception allows for penalty-free withdrawals of up to $10,000 over a lifetime for a first-time home purchase. To qualify, the funds must be used for buying, building, or rebuilding a principal residence for yourself or a close relative, and the money must be used within 120 days of the withdrawal. While the penalty is waived, the withdrawal from a Traditional IRA remains subject to ordinary income tax.

Higher Education Expenses

Another exception covers qualified higher education expenses for yourself, your spouse, children, or grandchildren. These expenses can include tuition, fees, books, supplies, equipment, and room and board if the student is enrolled at least half-time at an eligible educational institution. There is no specific dollar limit on the amount that can be withdrawn penalty-free for education, but the amount cannot exceed the qualifying expenses paid in the same calendar year.

Medical Expenses and Disability

Withdrawals for unreimbursed medical expenses exceeding 7.5% of your adjusted gross income can also be made penalty-free. Additionally, if you become totally and permanently disabled, you can take penalty-free distributions from your IRA. This requires proof that your condition prevents substantial gainful activity and is expected to be long-term or result in death.

Substantially Equal Periodic Payments (SEPP)

A series of substantially equal periodic payments (SEPP) also allows for penalty-free withdrawals before age 59½. Under this rule, you must take payments over a period based on your life expectancy, and these payments must continue for at least five years or until you reach age 59½, whichever period is longer. Deviating from the established payment schedule can result in retroactive penalties and interest.

Withdrawing Funds from an IRA

To initiate a distribution from an IRA, the account holder contacts their IRA custodian, such as a bank or brokerage firm. The custodian will provide the necessary distribution request forms, which must be completed for proper processing. These forms require details about the withdrawal amount, the reason for the distribution, and how the funds should be disbursed.

When requesting a distribution, tax withholding decisions are required. For federal income tax, a default withholding rate of 10% applies to taxable IRA distributions, unless a different amount is elected. Account holders can choose a higher withholding rate or to waive withholding entirely, though certain circumstances, like distributions delivered outside the U.S., may have mandatory withholding requirements. Consider your overall tax situation and consult a tax advisor, as insufficient withholding can lead to underpayment penalties. The IRA custodian will report the distribution to the IRS on Form 1099-R.