Roth IRA Withdrawals: The Exceptions Can Be as Important as the Rules
by , CFP®, President, Charles Schwab Foundation; Senior Vice President, Schwab Community Services, Charles Schwab & Co., Inc.
October 6, 2010
I'm thinking of taking a distribution from my Roth IRA. What are the concerns? Are there any penalties?
This is a great question because what on the surface seems very simple—distributions from a Roth IRA are tax-free—can quickly get bogged down in rules and exceptions unless you fit within a very strict definition. The reason is that, while under certain conditions Roth IRA distributions are definitely tax and penalty free, there are numerous situations in which you might be hit with taxes and/or penalties. It all depends on how long you've had your Roth IRA, your age, and what you plan to do with the money.
As always when it comes to tax issues, I suggest you talk to your accountant or tax advisor. But I can at least give you a run down on the basics so you'll be armed with some information beforehand.
The basic rules
Roth IRA contributions are made with after-tax dollars. Because you've already paid income taxes, you can always withdraw the contributions
to your Roth IRA tax and penalty free at any time. That's the simple part. But the beauty of a Roth is that the earnings
can also be tax and penalty free. And that's where distributions can get more complicated.
The IRS makes a distinction between what they call qualified
distributions. For a distribution to be qualified, that is, the earnings are not taxable or subject to penalty, you have to have held your Roth IRA for a period of five tax years and
meet one of the following conditions:
- You must be at least 59½.
- You use the money to pay for a first-time home ($10,000 lifetime cap).
- You become disabled.
- The distribution is made to a beneficiary or to your estate after you die.
So let's say you opened a Roth IRA in 2000 and have made yearly contributions amounting to $50,000. With your earnings, your account is now worth $56,000. Let's also say you turned 59½ in '09. Now you want to withdraw the total. You meet both the 5-year holding period and the age qualifications, so there's no problem. You won't owe any taxes or penalties.
Now let's change the scenario a bit. Let's say you're only 45 (and you're not disabled or buying a first house). In this case, your distribution is nonqualified. If you take out the total amount, you'll be taxed on the $6,000 in earnings at your ordinary income tax rate. But that's not all. Because you're not 59½, and you don't meet the other conditions, you might also have to pay a 10 percent early withdrawal penalty on your earnings.
I say "might" because, as with all rules, there are exceptions.
In general, if you withdraw money from your Roth IRA before you've met the 5-year holding period and/or before you reach 59½, not only is the earnings portion of the distribution taxable, but you could be subject to a 10 percent penalty on those earnings unless the distribution is used for one of the following exceptions:
- Qualified higher education expenses for yourself and/or eligible family members
- Unreimbursed medical expenses that exceed 7½ percent of your adjusted gross income
- Health insurance if you're unemployed
- The distribution is made in substantially equal periodic payments over the period of your life expectancy.
Another important factor is the order in which funds are taken out. Fortunately, the IRS rules for Roth IRAs work in your favor here. Withdrawals first come from contributions (which are not subject to any holding period), then from Roth conversions, and finally from earnings. So how much you're withdrawing and what percentage comes from earnings will also determine the extent of any taxes and penalties.
A word about Roth IRA conversions
If you've converted your traditional IRA into a Roth, there's yet another set of distribution rules. Unlike contributions to a Roth that come from your income, if you’re under 59½ contributions from a conversion must
be held in your account for five tax years from the time of the conversion to be penalty free upon withdrawal.
Talk to your tax advisor
As you can see, unless you fit the specific conditions for a qualified distribution, there are plenty of things to consider. Once again, as with all tax issues, talk to your advisor. It's the best way to avoid losing money—and sleep!
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