Advantages & Disadvantages of Liquidating IRAs

You can own, but not use, a vacation home held in your IRA. Images

Individual retirement accounts are designed to help you save for retirement. Penalties apply if you take money out prior to your golden years. Usually, tapping your nest egg for anything but retirement is a no-no, but there are a few, limited circumstances in which it might be advantageous to liquidate some of your IRA nest egg.

Early Withdrawal Penalties

If you're under 59 1/2, a huge disadvantage to liquidating your IRA is the early withdrawal penalty. The IRS slaps taxable distributions from your traditional IRA with an extra 10 percent penalty on top of the taxes you're already paying. The rules are a bit different for Roth IRAs. Not only do you have to be 59 1/2, you also must have a Roth IRA for five years before all your withdrawals escape the early withdrawal penalty. However, since your contributions weren't deductible, you can withdraw all your contributions out tax-free prior to age 59 1/2.

End of Tax-sheltered Growth

Besides the negative tax consequences, liquidating your IRA also means no more tax-sheltered growth of your retirement nest egg. Any additional earnings on the money you withdraw counts as taxable income in the year you earn it, which slows your growth rate. For example, say you take out $10,000 from your IRA and put it in a certificate of deposit. If you earn $500 of interest, that gets added to your taxable income for the year. If the money stayed in your IRA, you wouldn't pay any taxes on that $500 until you withdrew it; in the case of a Roth IRA, you pay no taxes at all on earnings when withdrawn after age 59 1/2.

Investment Options

Though there aren't many restrictions, the IRS does limit what you can invest in when the money is in your IRA. First, collectibles are out, so no matter how certain you are that certain works of art, baseball cards or gems are going to go up in value, you can't invest in them with your IRA money. Second, you can't make personal use of the investments in your IRA. Though that might not be a big deal if your investments are stocks and bonds, it could make a difference if you're investing in real estate. For example, if you think a beach condo in Florida is a good investment, you can hold it in your IRA, but only if you don't use it. If you cash out money from your IRA and use it to buy the condo, you can still watch the value go up and use the condo whenever you wish.

Paying Off High-interest Debt

If you have high-interest debt, you might save money by paying it off with money taken out of your IRA especially if you're over 59 1/2 and don't have to pay the early withdrawal penalty. For example, say you have $15,000 in credit card debt that's costing you 20 percent per year in interest. If you're only earning 5 percent or even 10 percent in your IRA, you're paying more in interest than you're earning on your investments.