Withdrawals and deposits: it’s all about compounding
Investment accounts typically have rules for how you may deposit and withdraw money. The manner and timing of your deposits and withdrawals can affect your investment performance as well. In general, leaving your money in investments that can increase in value and benefit from compounding over time is ideal.
Essentially, withdrawing money from your investment accounts, especially early on in the growth of an account, can have a harmful impact on your investment results because those funds are no longer able to generate compounded returns over time. This investment concept is called the “sequence-of-returns risk.”
It’s usually ideal to allow your investments to grow undisturbed, and to reap the benefits later, than to spend the money first and try to make up the difference later. When it comes to growing your investments, look but don’t touch!
Deposit rules depend on your account type
Depositing funds in an investment account is usually relatively straightforward. Standard taxable accounts, including brokerage accounts and mutual fund accounts, usually can be funded with any amount at any time. Deposits get more complex with non-taxable retirement accounts, including 401(k) and IRA accounts, where maximum contributions (i.e., maximum deposits) and income limits are usually imposed.
For example, the maximum allowable contribution in a traditional IRA is currently $5,500 if you’re under the age of 50, or $6,500 if you’re 50 or older. Whether you can deduct this from your income for tax purposes depends on your filing status and an income calculation. Many single tax filers receive benefits up to an income level* of $73,000, while married, joint filers receive benefits up to $121,000.
Withdrawals and distributions vary by account type
How you may withdraw funds also depends on the type of account, but the rules can be stricter. As expected, withdrawing from taxable accounts can occur at any time, although you will be liable for taxes on realized gains from investment sales. For non-taxable accounts, the rules differ by the type of account and why the withdrawal occurs. For instance, withdrawing from a traditional IRA before the age of 59 ½ will usually incur a 10% penalty and trigger a tax bill as well, because your initial investment was tax-exempt.
However, there are myriad exceptions to be aware of. For traditional IRAs, you can withdraw funds for qualified higher education expenses without incurring a penalty. Similarly, you can withdraw $10,000 for a first-time home purchase without incurring a penalty either.
It’s worth mentioning that Roth IRAs are treated differently. Since you already paid taxes on your initial investment to a Roth, that amount can be withdrawn at any time, even before age 59 ½. However, this amount can’t simply be re-deposited if you change your mind. Again, there are numerous rules, penalties, and tax implications surrounding deposits and withdrawals from these accounts, so it’s important to consult an advisor.
Staying focused on long-term goals pays off
From an investment perspective, many investors are tempted to sell their investments and withdraw funds when the market hits a snag. This often happens when headlines suggest that the market can only continue to fall or that investors should cash in their chips. Historically, it’s paid off to ignore this short-term chatter.
Instead, those investors who stay invested, resist the urge to withdraw funds, and even invest more when the market is cheaper, tend to increase their odds of building long-term wealth. If you’re more comfortable being in cash, you can withdraw money from your investment account; however, you may miss out on returns if the market goes up once your investments have been liquidated (i.e., sold).
- Modified adjusted gross income, or “MAGI”