The Roth IRA Early Withdrawal Penalty
What's the Roth IRA early withdrawal penalty?
Typically, it's a 10% penalty on investment gains withdrawn from your Roth IRA prior to age 59 ½.
This means that unless you meet one of the early withdrawal exceptions, your withdrawal must meet two criteria in order to be classified as a qualified distribution which is tax-free and penalty-free.
What are the two criteria?
You must meet both requirements before you can confidently withdraw funds tax-free and penalty-free from your Roth. Of course, there are exceptions.
So let's take a closer look at the rules...
Roth IRA Distributions After Age 59 ½
Any distributions of investment gains taken from your Roth IRA prior to age 59 ½ are considered early withdrawals.
Other than the exceptions highlighted below, early withdrawals are subject to income taxes as well as the Roth IRA early withdrawal penalty.
Notice the phrase "of investment gains." That's important...
Because you need to differentiate between your original Roth IRA contribution and the earnings (investment gains) which result from that contribution.
Original Roth IRA contributions can be withdrawn at any time tax-free and penalty-free.
After all, Roth IRA contributions are non-deductible, so you funded your Roth IRA with after-tax funds. Because you've already paid income taxes, you shouldn't have to pay a second tax bill just to gain access to your money.
But Roth IRA investment gains are a different story...
Think about it... If you have investment gains in a regular taxable brokerage account, those gains are subject to taxation. And we both know how much the government loves to tax your money.
So if you make an early withdrawal of investment gains from your Roth IRA, the government is going to want its share.
So remember, you can withdraw your original Roth IRA contribution at any time tax-free and penalty-free.
But if you withdraw any Roth IRA investment gains prior to age 59 ½, then you'll owe income taxes and a 10% Roth IRA early withdrawal penalty on those funds.
Find that hard to follow?
Here's an example...
At age 25, you open a Roth IRA and contribute $3,000. You never make any additional contributions.
Fifteen years later, you decide to close the account. It's now worth $10,000.
How much of that $10,000 do you get to keep?
Well, in closing the account early, you don't owe any taxes or penalties on $3,000 of the $10,000.
Because you can withdraw your original contribution any time both tax-free and penalty-free.
But the remaining $7,000 is considered an investment gain. As a result, it's subject to income taxes and a 10% Roth IRA early withdrawal penalty.
So assuming a tax rate of 25%, you owe $1,750 in income taxes as well as a $700 early withdrawal penalty... Meaning $2,450 of the $10,000 goes to taxes and penalties.
That leaves you with a grand total of $7,550 after closing your account.
An early withdrawal of your original contribution is always...
Tax-free and penalty-free.
But an early withdrawal of your investment gains prior to age 59 ½ is subject to...
A 10% Roth IRA early withdrawal penalty as well as applicable income taxes.
The 5 Year Rule
Even if you reach age 59 ½, you still need to meet one more requirement before you can withdraw funds tax-free and penalty free.
It's called the Roth IRA 5 year rule.
And as a general rule, it means your Roth IRA needs to be funded for at least 5 tax years before you can make tax-free and penalty-free withdrawals.
Need an example?
Let's say at age 59 your accountant informs you that it's a good idea to convert your Traditional IRA to a Roth IRA. You do that in the year 2007, paying the applicable income taxes required by such a conversion.
The funds continue to grow and in 2010, at age 62, you decide to withdraw those funds.
Can you do so tax-free and penalty-free?
Even though you've reached and surpassed age 59 ½, you still haven't met the 5 year rule for that portion of your money which represents the conversion. And you need to meet the 5 year rule before you can withdraw your investment gains tax-free and penalty-free.
The original contributions can still be withdrawn tax-free and penalty-free.
But the investment gains need to meet the 5 year rule before they can be withdrawn tax-free and penalty-free.
In this case, only four tax years have passed. 2007... 2008... 2009... and 2010.
You meet the requirements of the 5 year rule and are able to withdraw funds in the January following the fifth tax year.
In this case, 2011 is the fifth tax year. So January 2012 is when you can start to withdraw investment gains both tax-free and penalty-free from you Roth IRA.
Early Withdrawal Exceptions
By now we've learned that if your Roth IRA meets the 5 year rule and you've reached age 59 ½, then you can withdraw funds tax-free and penalty-free.
But are there other cases when you can withdraw investment gains from your Roth IRA without having to pay taxes and penalties?
Tax-Free, Penalty-Free Withdrawals
Tax-free, penalty-free withdrawals are known as qualified distributions, and there are a number of cases where you can take qualified distributions prior to age 59 ½ and even before you've met the 5 year rule.
Below are three (3) such instances...
1) Death - You avoid triggering the Roth IRA early withdrawal penalty if you die and your beneficiary closes your Roth IRA account. Apparently, the IRS finds it highly unlikely you'll hatch a conspiracy to die in order to avoid paying a 10% penalty. As a result, your beneficiaries can withdraw funds without getting hit with an early withdrawal penalty.
2) Disability - If you become disabled according to the definition in IRS Code Section 72(m)(7) and IRS Publication 590, then you can take a distribution from your Roth IRA tax-free and penalty-free. However, make sure you consult with a tax attorney or an accountant in order to verify that you meet the government's definition of "disabled." You don't want to get hit with unexpected taxes and penalties!
3) Purchase of a First Home - If you withdraw funds to pay for the cost of purchasing a first home for yourself, your spouse, your children, and/or your children's descendants, then you can take a distribution from your Roth IRA without having to pay income taxes or the 10% Roth IRA early withdrawal penalty. However, this is limited to a lifetime total allowance of up to $10,000.
What does that mean?
It means you can do this four times for four different family members at $2,500 a pop. Or you can do it once for $10,000. Or you do innumerable other combinations that add up to $10,000. But once you hit that $10,000 mark, you can't ever take advantage of this tax-free, penalty-free distribution again.
In addition to tax-free, penalty-free withdrawals, you can also take advantage of penalty-free withdrawals in certain instances.
However, since these are ONLY penalty-free distributions, your investment gains are still subject to income taxes if withdrawn.
Below is a list of five (5) qualifying events in which the Roth IRA early withdrawal penalty is waived...
1) Higher Education Expenses - You can withdraw funds from your Roth IRA early without penalty if you're using the funds to pay for qualified higher education expenses for yourself, your spouse, your child, and/or any descendant of your child.
So what are "qualified higher education expenses"?
Tuition, fees, books, supplies, equipment, room and board, and some additional expenses at any eligible educational institution.
Repayment of student loans are not counted as "qualified higher education expenses," so make sure to do your homework. If you have questions, IRS Publication 970 outlines the rules and regulations governing Tax Benefits for Education.
But remember, if you withdraw investment gains in addition to your original Roth IRA contributions, those investment gains are still subject to income taxes.
2) Substantially Equal Periodic Payments - If you receive a series of "substantially equal periodic payments" based on your current life expectancy, you can avoid paying the 10% Roth IRA early withdrawal penalty. However, any investment gains withdrawn are still subject to applicable income taxes.
3) Unreimbursed Medical Expenses - If you use the withdrawn funds to pay for unreimbursed medical expenses which exceed 7.5% of your adjusted gross income (AGI), then you can avoid paying the 10% Roth IRA early withdrawal penalty. However, any investment gains withdrawn are still subject to applicable income taxes.
4) Medical Insurance Premiums - If you use the withdrawn Roth IRA funds to pay for medical insurance premiums after receiving unemployment benefits for more than 12 weeks, you can avoid paying the 10% Roth IRA early withdrawal penalty. However, any investment gains withdrawn are still subject to applicable income taxes.
5) Payment of Back Taxes - The IRS allows you to withdraw funds from your Roth IRA early without paying the 10% early withdrawal penalty if those funds are used to pay off back taxes resulting from an IRS levy placed against you. However, any investment gains withdrawn are still subject to applicable income taxes.
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