IRA Accounts are Unsuitable as a Primary Savings Vehicle

It is a mistake to open an IRA before accumulating a significant level of savings first.  I have had two of them, both when I was just starting out, and they are both gone because I didn’t understand this idea.

In the late 90’s a lot of talk about IRA greatness came my way, both from personal acquaintances and financial institutions.  I bought right in:  “You have to save for retirement and this way the money grows tax free.  What could be better?  Sure the budget is a little tight right now.  But it’s important to start saving for retirement early so you have enough.  Plus each year your earning power will probably go up at least a little and the account will become easier to support.”

The problem is that life doesn’t move up in a straight line.  Life behaves more like the stock market with up times, down times and times when things move sideways for a while.  During a down time it may be necessary to use savings.

When I needed money the IRS was a winner both times.  Normal income tax on the distributions was due of course.  But I also had to pony up a 10% penalty for withdrawal before retirement.  My distributions were fairly small.  But I know of a highly-paid computer programmer who spent several years living off IRA savings after being laid off, and I’m sure the penalty taxes for her were horrendous.

The government probably does a good amount of business this way.  My conclusion comes from seeing many people make early withdrawals over the years.  In fact, to venture a guess, I’d say one reason they allow IRA accounts is the likelihood that people will need to break them.  Thousands, if not millions, of people taking early withdrawals every year could add up to significant cash flow.

There are several exceptions that allow for penalty-free withdrawal.  But if you read the list you’ll notice that none of them are things like, “your car needs a new transmission” or “you got laid off and don’t have any money coming in right now” or “Your credit cards have gotten high and need to be paid off”.  Figuring out how these exceptions work also creates hassle.  Time, money or both will be required to find out if one applies to your situation.  This involves either consulting an accountant or doing some legal research on your own.

If you already have, let’s say, one year’s worth of living expenses saved opening an IRA for additional tax-sheltered savings makes sense.  But don’t turn that corner until you have a war chest built up in taxable accounts first.  You need to be able to burn through savings in an emergency before you ever get close to your IRA money.  Otherwise you’ll end up with a complicated situation and more tax liability at a time when things are already probably up in the air.

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