The Roth IRA is one of the best ways I know of to save for your retirement. You really can’t beat the tax free status of withdrawals at a time when your salary has stopped. Contributions to Roth IRA’s should be left in there at all possible costs so that you have the maximum available when you need it at retirement.
Of course, we all know that sometimes we are forced to tap into our retirement nest egg before we intended — we lose our jobs, family medical emergency, some large unexpected debt arises, etc. If you get hit with such a sudden expense, what do you do about your Roth IRA?
If at all possible, use up other resources first. Even if the other resources were tax deferred plans, they may have exception clauses that will lessen the penalties upon withdrawal. Depending upon the nature of the emergency, you might consider taking out a loan or using your home equity line so that you don’t have to tap your IRA’s. But if you have to make a withdrawal, you’ll need to understand the tax bite the IRS will take.
Withdrawals depend on Tax Status
The contributions that you put into a Pension, Profit Sharing or Roth IRA plan can always be taken out at any time totally tax free. Why? Because — your contributions were already taxed when you earned the money as salary. They are called After-Tax contributions. Contributions you made into a regular 401k or Traditional IRA plan are taxable upon withdrawal since you got a tax break when you put the contributions into the plan.
If the government tried to tax your own contributions coming out of a retirement plan, they would be taxing you twice on the same money. Even our government wouldn’t do this. The IRS gets their bite of your dollars only once, and that’s it.
The Roth IRA Withdrawal Rules
Since your own contributions can always be taken out tax free, all the rules discussed below apply only to the investment or interest earnings in your Roth.
There are 3 types of distribution rules which will determine taxability of earnings:
- Qualified Distribution – withdrawal is totally tax free
- Non- Qualified Distribution -taxable as ordinary income with an additional 10% penalty
- Non-Qualified with Exception – taxable as ordinary income, but no 10% penalty
Qualified Distribution or Withdrawal
You can get all your money out of a Roth totally tax free under the following conditions:
1. A) Withdrawal is made on or after the date you reach age 59½,
B) 5 year rule – Your oldest contributions to a Roth must have been in there for at least 5 years. Once your oldest contributions meet this rule, you have satisfied the rule for ALL of you Roth contributions, even those made this year.
The 5 year rule applies regardless of your age when you opened the IRA. Normally under IRA’s you can make penalty free withdrawals after 59½, but if you made your first contribution at age 56, you would need to wait until age 61 to take out any the earnings tax free on that portion of your contributions.
2. You withdraw money because you are disabled,
3. Distribution is made to your beneficiary, or to your estate after your death, or
4. If you use money toward the cost of your first home, or the first home of your children or grandchildren. (Up to a $10,000 lifetime limit).
Non-qualified distributions or Withdrawals
Non-qualified distributions are withdrawals which do not meet the requirements of a qualified distribution. In general, if you take a withdrawal prior to 59 ½ and satisfying the 5 year rule, your earnings will be taxed as ordinary income and you will receive a 10% penalty on the amount withdrawn.
Non-Qualified with Exception
There are a bunch of exceptions that permit you to take withdrawals from your Roth IRA that are subjected to ordinary income taxes, but without a 10% early withdrawal penalty. These include:
- If you withdraw equal payments until you meet the five year rule or you reach age 59½, whichever is longer. So, if you want to withdrawal $4,000, and you are age 55 1/2, taking out $1,000 per year for 4 years will allow you to avoid the 10% penalty. You will still have to pay ordinary income taxes on the earnings.
- You have unreimbursed medical expenses exceeding 7.5% of your Adjusted Gross Income (AGI).
- You are paying medical insurance premiums after losing your job.
- The distributions are not more than your qualified higher education expenses yourself, your spouse, your children, or their descendants.
- The distribution is due to an IRS levy of the qualified plan.
- The distribution is a qualified reservist (military) distribution.
- The distribution is a qualified disaster recovery assistance distribution.
The higher education exception above makes the Roth a popular method of saving for college expenses. Learning to invest your money for retirement is just one piece of having good business savvy.
Pros and Cons of Taking Early Roth IRA withdrawals
Your ability to make tax and penalty free withdrawals from a Roth IRA gives you a level of flexibility that you don’t have with other retirement accounts. But should you do it? Doing so may hurt your long term retirement planning. Remember, the purpose of a Roth is to accumulate retirement funds and it serves this purpose quite well. Taking an early withdrawal will just reduce the amount you have live on later.
Compound interest is a very powerful phenomenon in the financial world, but making a withdrawal reduces the amount of money you have working for you and reduces the amount of time your money has to compound. Again, I recommend looking at all other options before pulling out money early from your Roth IRA.