Withdrawing funds from your retirement accounts must be done carefully to avoid a potential 10% early withdrawal penalty. Unfortunately, each retirement account type has different rules. Here are some tips for Roth IRAs.
Roth IRA basics
Roth IRA accounts differ from other IRAs in that your contributions are made in after-tax dollars. If you follow the Roth IRA rules, your withdrawals of any earnings in the account can be tax-free. Generally, to take advantage of the tax-free distribution from a Roth IRA:
- You must be age 59½ or older.
- You must have had funds in the Roth IRA account for more than 5 years.
- You must understand what is being distributed (contributions, converted funds or account earnings).
- You must know your possible tax-free distribution options.
If you do not comply with these rules you could be subject to income tax and a 10% early withdrawal (distribution) penalty. But wait! There are ways to avoid getting taxed and the early withdrawal penalty.
Roth IRA distribution tips
- Plan around the 10% early withdrawal penalty. Prior to withdrawing funds, ask for help to ensure you know whether you will be subject to the early withdrawal penalty.
- Remember that contributions have been taxed. What many forget is that your initial contributions have already been taxed. The portion of your early distribution from a Roth IRA account subject to income tax is only the untaxed earnings on your contributions.
- Qualified early withdrawals. If you use the distributions for a qualified reason, you can avoid the early distribution penalty. Some of the more common qualified early withdrawals from a Roth IRA are used for:
- College. If you withdraw Roth IRA earnings to pay for college expenses, you will pay tax on the earnings withdrawn, but you will not be subject to the 10% early withdrawal penalty.
- First-time home buyer. Even if you’ve had your Roth IRA for less than five years, you can withdraw up to $10,000 in Roth IRA earnings tax-free and penalty-free if it is used to buy a first home.
- Account holder disability or death.
- Unreimbursed medical expenses that exceed your itemized deduction threshold.
- Substantially equal periodic payments. These must be made over the defined life-expectancy of the IRA holder using specific rules to avoid the early withdrawal penalty.
- No minimum withdrawal requirements. The Roth IRA rules do not require you to take money out when you reach a certain age. This means you can have an estate-planning strategy to never withdraw the funds in your Roth IRA. While the funds would be considered part of your estate, your heirs could withdraw the funds tax and penalty-free.
- Keep separate accounts. The taxability of a withdrawal can be complicated. Are you withdrawing contributions, converted funds or earnings? How long have the funds been in the Roth IRA? Because Roth IRA distribution rules can be complex, if you convert funds from another retirement account into a Roth IRA, do so in a separate account. It will then be easier to understand the impact of a withdrawal from the account.
If you have questions regarding your situation, speak to an advisor prior to taking any withdrawals from a Roth IRA or other tax-advantaged retirement plan.