If you make a mistake investing with your IRA, penalties can severely damage your nest egg. Start with tax and early withdrawal penalties: if you pull any money out of your traditional IRA, you have to pay any taxes due (which means they count as income, potentially moving you up a tax bracket or two) and ten percent of the total amount you withdraw is also forfeit to the IRS. This can add to quite a lot of money.
In a Roth IRA, penalties are similar, but because you've already paid tax on your contributions, you won't owe income tax on the principal. It is possible that you will owe income tax on some of the money that has accumulated, and you will also have to pay that 10% surcharge.
IRA penalties will be due if you withdraw cash from your IRA before it's time to disburse it, but you may also find yourself paying IRA penalties in certain other situations. For instance, if you have been self-investing your IRA and make the mistake of investing in something you take too close an interest in - for example, you've invested in a building that you also lease an office in - you may find yourself paying for what the IRS has determined is an early disbursement.
If you overcontribute to your IRA, you may also find yourself in a pickle. IRA penalties for overcontributing include paying late taxes due (in the case of traditional IRAs), fines, and sometimes other expenses. You should carefully avoid either overcontributing or undercontributing to your IRA.
This doesn't mean you can't touch your IRA. In a few cases, you can withdraw money from your IRA penalties-free, but you must understand what you're doing and how the different rules apply to your IRA. It's easier to use a Roth IRA in this way, but even a traditional IRA can be a source of cash in certain situations.
You can withdraw money from your IRA penalties-free if you are purchasing a home for the first time in two years. You're eligible to withdraw up to $10,000 for yourself (your spouse can do the same with his or her individual IRA), and you can use the cash for your own home or for that of a parent, child, or grandchild. Your lifetime individual limit is $10,000. You may also withdraw cash without interest to use for qualified educational expenses, from tuition to board.
Your IRA can also be used to pay for medical insurance once you've been unemployed for 12 consecutive weeks, or to fund certain medical expenses if they exceed 7.5% of your gross income.
If you become disabled, you can treat your IRA as if you've already retired. If you are a qualified reservist called to active duty, you may be able to avoid the 10% fee (talk to your command about this - the rules are changing to accommodate people as they get called up). And in a couple of other situations - when your life expectancy is shortened, for instance - you may be able to have your IRA qualified for regular disbursement early.
In no case should you withdraw money from your IRA without good reason, regardless of penalization. IRA penalties are there to protect you and your retirement investment. If you were allowed to withdraw money whenever you want, the constant temptation would likely lead to a lot of IRAs being used as personal piggy banks. Instead, protect your IRA and pull money from it only when it's absolutely necessary and when it will be a major benefit to your life, helping you build toward retirement rather than just helping you out today.
