It only takes one wrong move for your retirement account to transform from a golden egg into a finger-shattering bear trap. I found this out the hard way, by losing thousands of dollars to the U.S. Treasury.
With any luck, you won’t have to. The key to salvation rests in patience. Patience, and knowing what it really means to open a traditional individual retirement account (IRA).
Why your traditional IRA is risky
A traditional IRA is risky because you could be charged massive early withdrawal fees.
A traditional IRA, the most common type of retirement account, offers you tax benefits for buying stocks through the account. You can build your nest egg tax free, and it’s touted as a great way to save money for retirement. It is, but only if you can weather decades of turbulence.
I had thousands of dollars invested in a traditional IRA. Then COVID-19 hit. My budget was tight, and I needed money. I withdrew it from my IRA. In doing so, I condemned myself to paying a massive 10% early withdrawal fee, plus taxes — bleeding thousands of dollars of cash.
It happens. It’s also why your traditional IRA may be your riskiest investment. If you don’t have a cash cushion to fall back upon, your retirement account could end up costing you big time.
How to avoid paying early withdrawal fees
Avoid paying early withdrawal fees by saving an emergency fund.
When times are tough, the best thing you can do is to withdraw from a cash account. A high-yield savings account is a great place to build an emergency fund. You can withdraw with no penalty. When interest rates are high, you can even earn significant money on your savings.
Another way to avoid fees is to open a taxable brokerage account. You won’t get tax advantages on your investments, but you can withdraw at any time — without paying fees. Since my original IRA fiasco, I’ve opened up a taxable brokerage account I can withdraw from, just in case.
A third option is to open a Roth IRA. A Roth is similar to a traditional IRA, but there are key differences that make a Roth preferable in many situations. In fact, I prefer the Roth.
Traditional vs. Roth IRA
You can withdraw early from Roth IRAs without paying early withdrawal fees.
Roth IRAs offer slightly different tax advantages than traditional IRAs, but the main point here is flexibility. You can withdraw your contributions (but not investment growth) from a Roth IRA anytime without paying an early withdrawal fee. A traditional IRA forces you to wait until you’re retired to withdraw penalty free.
Roth IRAs let you do this because you pay your taxes upfront. You only benefit from the tax advantages of a Roth IRA when you withdraw money tax free during retirement. You won’t get these benefits when withdrawing early, but nor will you pay penalties if you withdraw only your contributions.
There are times when you can withdraw from a traditional IRA early without paying penalties:
- First-time home purchase
- Educational expenses
- Disability or death
But a Roth IRA is more flexible overall. Consider opening a Roth instead to make investing for retirement less risky. You could save thousands of dollars lost to the U.S. government should you need to withdraw your money early.
