If I Take Funds Out of My IRA, Can I Repay Them Before the Year Is Out Without Penalty?

A number of classic movies have used lifeboats as a stage for their drama, drawing on the torment of being surrounded by water yet dying of thirst. Investors sometimes find themselves grumbling about a milder version of that same dilemma: having a short-term financial need while all their money is tied up in IRAs or other long-term investments. Usually withdrawing those funds is counterproductive, but sometimes you can repay them without penalty.

If you have Roth and traditional IRAs, the Roth is your easy option for a short-term withdrawal. You contribute to your Roth IRA with after-tax dollars, so every dollar you put in can be withdrawn without penalty in time of need. You can choose to repay the funds or not: it has no effect on your taxes. There is a difference between the dollars you've contributed to your Roth and the earnings on those contributions. The earnings are taxable unless they've been in the plan for five years. If you withdraw them before you're at least 59 1/2, you will also incur an extra 10 percent tax penalty on the amount of earnings withdrawn.

With traditional IRAs, things are different because you've received a tax deduction for the dollars you contributed. If you withdraw from the account, those dollars are taxable at your highest rate for the year and you will also incur an extra 10 percent tax penalty if you're under the age of 59 1/2. However, if you repay the funds within 60 days, there is no cost. This provision is intended to let you move money between IRAs, but it also works as a sort of short-term loan. Be very wary of doing this: if you can't repay, or if you're even a day late, you pay the full penalty at tax time.

The IRS recognizes specific exceptions to the penalty for withdrawals. Some center around hardships, such as a disability or unusual medical expenses. Others are opportunities, such as buying a house or paying educational costs. Again, these are not intended as a way to borrow funds from your long-term investments to meet a short-term need. However, if you legitimately qualify for one of these exceptions and have some unused space under the contribution cap for the year, you can withdraw funds from the IRA and later return an amount equal to your remaining contribution space.

Remember that the rules can change between taxation years, and advice that's valid one year might be outdated by the next. Research a potential withdrawal before committing to it: the world of taxes is filled with pitfalls for those who've skimped on due diligence. In many cases, the potential tax ramifications make these withdrawals risky unless you're absolutely certain you can repay the funds within that 60-day window. Don't think of it as "using some of my own money": that's technically true, but in practice, it's more like stealing away your own retirement. If you have other alternatives, you should probably explore those first.