Roth IRA Withdrawal Rules: What You Should Know

Ken Weingarten |
Categories
Roth IRAs
Retirement Planning

While the main point of a Roth IRA is to help you save for retirement (along with any other type of retirement savings account), life can take a sharp turn where you may be faced with the option to withdraw from a Roth IRA, which can result in potential taxes and/or penalties. Here we will go over what rules to keep in mind.

Roth IRAs are special in that any direct contribution can be distributed an any time, free of taxes and penalties. The earnings on said contributions make things a bit trickier. There are two rules that must be satisfied for a distribution to be tax free: a qualified distribution and the 5-year rule. Otherwise, you can face paying taxes or a penalty on the earnings portion of direct contributions.

Qualified Distribution

The following reasons/event are viewed as acceptable qualified distributions:

  • You are over Age 59 ½.
  • You are disabled.
  • You are a first-time homebuyer (up to $10,000)
  • You are the beneficiary of a Roth IRA

5-Year Rule

Any earnings distribution made before the fifth year after your first Roth IRA contribution will be taxed as ordinary income, which will be dependent on what your tax rate is at the time of distribution.

This 5-year period starts with your first contribution to any Roth IRA. Individuals with multiple Roth IRAs do not have to worry about multiple 5-year rules. The 5-year rule once needs to be met once. Any subsequent Roth IRAs opened and contributed to will be considered as held for five years.

10% Distribution Penalty

If both rules are not met, the earnings portion of the distribution will be taxed as ordinary income along with a 10% tax penalty. That said, there are exceptions to the 10% penalty, such as:

  • Distributions made to pay for unreimbursed medical expenses that exceed 7.5% of your AGI.
  • Distributions made to pay for health insurance premiums while unemployed
  • Distributions made to pay for qualified higher education expenses.

You will still have to pay ordinary income taxes on these distributions despite these penalty exceptions.

Distributions from Roth Conversion Contributions

Since Roth conversion contributions are not considered direct contributions to a Roth IRA, they may face the 10% penalty upon distribution. Since these converted amounts were taxed at the time of the conversion, they will not be subject to ordinary income taxes.

Distribution Order

Thankfully, the IRS has made it simple to distinguish whether a distribution is a direct contribution, conversion contribution, or earnings. If a distribution is made, they are assumed to occur in the following order:

  1. Regular, direct contribution
  2. Conversion contribution
  3. Earnings

 

Conclusion

While the option to make an early Roth IRA distribution is present, one should consider if making it is the right choice. The tax advantages of Roth IRAs are exceptional. One should carefully consider all other options before considering an early distribution from a Roth IRA. Consulting with a financial advisor can certainly help with making the right choice.

 

Weingarten Associates is an independent, fee-only Registered Investment Advisor in Lawrenceville, New Jersey serving Princeton, NJ as well as the Greater Mercer County/Bucks County region. We make a difference in the lives of our clients by providing them with exceptional financial planning, investment management, and tax advice.