Roth IRA Withdrawals

What are the rules for Roth IRA withdrawals?

You need to know.

Why?

Because if you don't know, then you might get hit with unexpected taxes and/or penalties...

In order to insure this doesn't happen to you, you need to make sure your withdrawal is a "qualified distribution."

Why?

Because qualified distributions are tax-free and penalty-free...

Okay, so what constitutes a qualified distribution?

We'll address that in-depth in another article.

But for now, you only need to keep in mind the following points...

• Principal can be withdrawn anytime penalty-free
• Earnings generally can NOT be withdrawn before age 59 ½ penalty-free
• Earnings generally can be withdrawn after age 59 ½ penalty-free
• Earnings on your principal contribution must be invested for at least 5 years
• There are special exceptions to the rules

Learn these four characteristics of a Roth IRA withdrawal, and you'll know just about everything you ever need to know about withdrawing funds from your Roth IRA...

(We'll let your accountant worry about the rest!)

Roth IRA Principal Contributions

Unlike a Traditional IRA, you can withdraw funds from your Roth IRA tax-free and penalty-free as long as you're withdrawing an amount equal to or less than your original contribution.

Why?

Well, it's your money.

And since you funded your Roth IRA with after-tax income, you've already paid income tax on it.

So you don't need to worry about incurring penalties or taxes when you withdraw principal contributions from your Roth IRA...

But you DO have to worry about taxes and penalties if you withdraw the earnings or gains that resulted from your original principal contribution.

For example, let's say you contribute $5,000 to your Roth IRA one year.

The next year, you decide you need that $5,000 after all...

But the $5,000 is now worth $5,500 because your investment gained 10% during the year.

You can withdraw the original $5,000 contribution tax-free and penalty-free.

But if you withdraw the $500 gain, it's subject to an early withdrawal penalty of 10% as well as income taxes...

Roth IRA Withdrawals Before Age 59 ½

As we previously covered, if you withdraw a principal contribution from your Roth IRA, it's always tax-free and penalty-free.

However, the same can not be said when it comes to withdrawal of investment gains from your Roth IRA.

If you're under the age of 59 ½, withdrawal of investment gains from your Roth IRA is almost always subject to...

• A 10% early withdrawal penalty
• Income taxes

There are a few exceptions, and those are addressed at the end of this article...

But, as a general rule, any withdrawal of a Roth IRA investment gain made prior to age 59 ½ is subject to both.

Need an example?

Let's say you open a Roth IRA and contribute $4,000 in the first year.

Three years later, you decide to close your Roth IRA...

But the original $4,000 contribution you made is now worth $6,000 due to a 50% investment gain.

You can withdraw the original $4,000 contribution tax-free and penalty-free.

But the $2,000 investment is subject to...

A 10% early withdrawal penalty and income taxes.

Assuming a 35% income tax rate, you owe income taxes of $700.

Your 10% early withdrawal penalty is $200.

So, by closing the account, you owe $900 and walk away with $5,100...

Roth IRA Withdrawals After Age 59 ½

On the day you turn 59 ½, and any day after that...

You can withdraw investment gains from your Roth IRA tax-free and penalty-free.

For example, let's say at the age of 30, you invested $5,000 in your Roth IRA and never made another contribution.

At age 60, your Roth IRA is worth $20,000.

Since you're older than age 59 ½, you can withdraw every penny of that $20,000 tax-free and penalty-free.

However, this assumes your Roth IRA meets the 5-year tax holding period...

Roth IRA Earnings Must Be Invested 5 Years

In order to withdraw investment gains from your Roth IRA tax-free and penalty, even after the age of 59 ½, your original contribution or Roth IRA conversion must have taken place at least five tax years prior to the withdrawal...

For example, let's say you opened a Roth IRA in 2007 at age 58 and contributed $5,000.

In 2009, even though you're 60 years old, you can NOT withdraw any of the investment gains on the original $5,000 contribution without paying taxes.

Why?

Because your Roth IRA has not yet met the five-year tax holding period.

Instead, you'll have to wait until January 2012 before you can withdraw investment gains tax-free and penalty-free.

Why 2012?

Because 5 tax years will have passed by then... 2007... 2008... 2009... 2010... and 2011.

Does that make sense?

Make sure you remember that the rule applies to the tax year, not the actual year.

Why does this matter?

Because you have until the April 15 tax deadline to make a contribution to your Roth IRA...

So, for sake of argument, let's say you make a $2,000 Roth IRA contribution for the 2008 tax year on April 1, 2009.

Your five-year holding period begins ticking in 2008 not 2009, because 2008 is the actual tax year of the contribution.

In this example, tax-free and penalty-free distributions can begin in January 2013...

Exceptions To Early Withdrawal

So far we've learned that if you withdraw investment gains from your Roth IRA either...

Before reaching the age of 59 ½...

Or

Before the 5-year tax holding period ends...

Then, you're subject to income taxes and a possible 10% early withdrawal penalty.

However, certain exceptions do exist.

If any of the following conditions apply, withdrawals of Roth IRA investment gains are NOT subjected to income taxes or an early withdrawal penalty...

1) You die and your beneficiary closes the account.

2) You become disabled according to the definition in IRS Code Section 72(m)(7) and IRS Publication 590.

3) You receive a series of "substantially equal periodic payments" based on your current life expectancy.

4) You use the withdrawn funds to pay qualified higher education expenses for either yourself and/or eligible family members.

5) You use the withdrawn funds to pay for the cost of purchasing a first home (limited to $10,000).

6) You use the withdrawn funds to pay for unreimbursed medical expenses which exceed 7 1/2% of your Adjusted Gross Income (AGI).

7) You use the withdrawn funds to pay for medical insurance premiums after receiving unemployment benefits for more than 12 weeks.

8) You use the withdrawn funds to pay back taxes due to an IRS levy placed against you.

However, keep in mind that these are rare exceptions. Make sure you consult your accountant before taking advantage of any one of these exceptions.

Otherwise, you run the risk of getting hit with an unexpected tax bill, IRS penalties, or worse...

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