You must take care to plan your retirement plan withdrawals 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 59 ½ 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 income tax and the early withdrawal penalty.
Roth IRA distribution tips
- Remember 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.
- 10% early withdrawals. Early withdrawal penalties are subject to the five year account rule and how you use the funds when distributed. It also might depend on what funds you remove from your account. Prior to withdrawing funds, ask for help to ensure you know whether you will be subject to the early withdrawal penalty.
- Qualified early withdrawals. If you use the distributions for a qualified reason, you can avoid the early distribution penalties. Some of the more common qualified early withdrawals with Roth IRA's are:
- 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 If you withdraw Roth IRA earnings to pay for college expenses, you will pay tax on the earnings withdrawn, but you will not be subject to the 10% early withdrawal penalty.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 income tax-free and penalty tax-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. Unlike other IRAs, the Roth IRA does not require you to take money out when you reach a certain age. With Traditional IRAs this withdrawal requirement occurs when you reach age 70 ½. This means you can have a strategy to never withdraw the funds in your Roth IRA as an estate-planning device. While the funds would be considered part of your estate, your heirs could withdraw the funds tax and penalty-free during their lifetime.
- 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 this can be complex, try to keep your Roth IRA accounts simple. 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 a qualified planner prior to taking any withdrawals from a Roth IRA or other tax advantaged retirement plan. It could save you plenty in potential tax and penalties.