Is It Worth Paying the 10 Percent Penalty to Cash Out an IRA to Buy a Rental Property?

There are ways around IRA early withdrawal penalties for rental property purchases.
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A rental property can be an excellent investment -- especially if you are able to buy one at a significant discount to market price. Pulling money out of your individual retirement account, or -- in the language of the IRS -- your individual retirement arrangement, may be a wise way to buy a rental property. However, given the onerous penalties involved with taking money from your IRA, there are other ways that could prove to be more profitable in the long run.

The Cost of Withdrawing Money from Your IRA

If you withdraw money from your IRA before you turn 59 1/2 for anything but a few specially designated purposes, the IRS hits you with a 10 percent penalty. If you pull $50,000 out of your IRA, you'll have to pay $5,000 in penalty tax on it, but that isn't the only tax you'll have to pay. The IRS will also require you to pay income tax on the money you pull out since you didn't pay it when you put it in. If you're in the 25 percent bracket, the tax on a $50,000 withdrawal is $12,500, leaving you with just $32,500. State income tax could reduce your proceeds further.

Determining Whether to Use IRA Funds

Knowing what it costs to pull money out of your IRA, the calculation becomes relatively simple. If $50,000 in your IRA can make you more money than $32,500 invested in a rental property, leave the money in the IRA. If not, take it out. If it's right on the line, it might make sense to pull the money out of the IRA since money left in the IRA will incur income tax when you withdraw it. However, you might also be able to buy property with your IRA money without having to pay the penalties or taxes.

Buy It In Your IRA

You can buy rental properties within your IRA by setting up a self-directed IRA account. Self-directed accounts allow you to choose the investments that sit in your IRA. If you do this, you will have to pay account maintenance fees and you must follow IRS rules and regulations. On the other hand, you'll be able to own the property and keep all of your money inside your IRA without losing any to taxes or penalties.

The IRS also allows you to effectively take a short-term loan from your IRA. If you withdraw money from the IRA, you don't have to pay taxes and penalties as long as you replace the money in that IRA or another IRA within 60 days. If you can come up with extra funds that quickly, you could use your IRA for short-term financing. Before using this strategy, talk to a tax professional to better understand if it is suitable for your situation.

Live in It

The IRS allows you to take up to $10,000 out of your IRA once in your lifetime to help with the expense of buying a home if you are a first-time home buyer. You will have to pay income tax on the deduction, but you will not have to pay the penalty. You obtain a residential mortgage with a low down payment, buy a property and live in it for a couple of years, and then convert it to a rental property.

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