The Roth IRA is a great investment option that offers tax free growth and tax diversification, and is an important part of many people’s retirement planning. Unfortunately, things don’t always go as planned and you may need to make a withdrawal from your Roth IRA before you reach retirement age. Thankfully, the Roth IRA is also one of the most flexible retirement account options because you can make tax and penalty free withdrawals of your Roth IRA contributions at any time. However, it is important to understand when you can make withdrawals of your earnings, otherwise you may subject yourself to a 10% early withdrawal penalty.
Roth IRA withdrawal Rules
In general, you can make tax and penalty free withdrawals of the principle (contributions) at any time. However, the earnings from your principle cannot normally be withdrawn under age 59½ without paying the 10% early withdrawal penalty. Earnings can generally be withdrawn without penalties after age 59½, provided you meet the 5 year rule.
Roth IRA 5 year rule. Withdrawals from your Roth IRA will only be classified as qualified distributions if it has been at least 5 years since you first opened and contributed to your Roth IRA, regardless of your age when you opened it. As an example, you can normally make penalty free withdrawals at age 59½, but if you made your first contribution at age 58, you would need to wait until age 63 to withdraw any earnings made on that portion of your contributions.
There are exceptions to these rules. Read on to learn more about qualified and non-qualified distributions, and as always, consult with a financial professional if you have any questions before you make any withdrawals or distributions.
Roth IRA Qualified and Non-qualified Distributions
It is important to understand the difference between qualified and non-qualified distributions before making any withdrawals or taking distributions from your Roth IRA. Provided your it meets the 5 year rule, a qualified distribution from your Roth IRA will be both tax and penalty free, which is important because either of these can seriously erode any gains your investments may have earned. A non-qualified distribution may trigger both taxes and early withdrawal penalties, decimating the value of the investments in your Roth IRA.
Qualified distributions. Qualified distributions are withdrawals that are both tax and penalty free. In most cases, withdrawals made after age 59½ will be qualified distributions, provided they meet the 5 year rule for investment gains. According to IRS Publication 590:
A qualified distribution is any payment or distribution from your Roth IRA that meets the following requirements.
1. It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and
2. The payment or distribution is:
- Made on or after the date you reach age 59½,
- Made because you are disabled,
- Made to a beneficiary or to your estate after your death, or
- One that meets the requirements listed under First home under Exceptions in chapter 1 (up to a $10,000 lifetime limit).
Non-qualified distributions. Non-qualified distributions are withdrawals which do not meet the requirements of a qualified distribution, and may be subjected to taxes or early withdrawal penalties. In many cases, non-qualified distributions will be taxed as ordinary income and be subjected to the 10% early withdrawal penalty.
Exceptions to early withdrawal penalty (aka 10% penalty)
There are some exceptions that allow you to make withdrawals from your Roth IRA that are subjected to ordinary income taxes, but are not subjected to the 10% early withdrawal penalty. Some of these include:
- The distributions are part of a series of substantially equal payments (minimum five years or until the Roth IRA owner reaches age 59½, whichever is longer).
- 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 (for yourself or eligible family members).
- The distribution is due to an IRS levy of the qualified plan.
- The distribution is a qualified reservist distribution.
- The distribution is a qualified disaster recovery assistance distribution.
- The distribution is a qualified recovery assistance distribution.
Order of Roth IRA Distributions
The IRS makes it easier for taxpayers to make penalty free withdrawals from their accounts by the way they assign the order of IRA withdrawals. Again, referring to IRS Publication 590, Roth IRA distributions occur in the following order:
- Regular contributions.
- Conversion and rollover contributions, on a first-in first-out basis.
- Earnings on contributions.
As you can see, regular contributions are the first to be withdrawn, and they can be withdrawn at any time without taxes or penalties. The taxable portion of your withdrawals is held until the end, making it easier for you to make a penalty free withdrawal.
Roth IRA Withdrawals for first home purchase or college expenses
Roth IRAs have a feature that allows account holders to make qualified distributions for a first home purchase or for qualified college expenses.
First home purchase withdrawal from Roth IRA. Early Roth IRA withdrawals for the purchase of a first home are allowed up to a $10,000 life time maximum per account. Withdrawals can be made for the purchase of your first home, or the benefit can be used for your children or grandchildren. However, the $10,000 limit is always in effect, regardless of who the money is used for.
Using a Roth IRA for college expenses. You can avoid early withdrawal penalties associated with early Roth IRA distributions if you use the funds for qualified higher education expenses for yourself, your spouse, your children, or their descendants.
Pros and Cons of early Roth IRA withdrawals
The ability to make tax and penalty free withdrawals from Roth IRAs is a level of flexibility not found in most other retirement accounts. But just because you can do it doesn’t mean you should. Even though you may not pay any taxes or penalties to withdraw some of your funds, doing so may hurt your long term retirement planning.
Roth IRAs offer a great tax diversification strategy and making early withdrawals, qualified or not, hampers your retirement planning and limits the amount of money you will have in retirement. Compound interest is one of the most powerful forces in the universe, but making withdrawals limits the amount of money you have working for you and reduces the amount of time your money has to compound, effectively reducing your potential retirement nest egg. I recommend looking at all options before making early withdrawals from your Roth IRA.
{ 16 comments… read them below or add one }
Great summary of a very important subject, Ryan. Everyone who’s eligible who make funding a Roth IRA a key part of their planning.
Now, as you’re probably used to from me… heh… I need to correct one small thing…
First, I believe you’ve misstated the 5 year rule. Or at least what’s in that first gray box is misleading. My understanding is it only needs to be 5 years from your *first* contribution. So that “age 58/63″ example is only true if you make your first contribution to *any* Roth at age 58. Not simply add to an existing Roth.
See here for my source (particularly Figure 2-1):
http://www.irs.gov/publications/p590/ch02.html#en_US_publink1000231061
Other than that, I just want to emphasis the ‘Substantially Equal Periodic Payments’ option, especially for people who retire early. Its a great and entirely legit ‘loophole’ for people who want to retire early. Even though you’ve probably repeatedly heard that you can’t access IRA money without penalty until age 59 1/2, that’s not really true.
Just make sure you know what you’re doing, or consult a professional if you’re not comfortable with it, because you have to withdraw enough, and continue doing so for long enough, in order to not end up owing all the back taxes & penalties that you’ve avoided.
Fred, thanks for that head’s up and for sharing the link to IRS pub 590. The item in question has been corrected.
Nice well written! Trying to go through the IRS rules on this is a nightmare. This is laid out very well.
Don’t forget that even though you are taking a non-qualified distribution, you can withdraw contribution at any time (before 5 years etc) penalty and tax free.
I also do not think than any distribution will be subject to ordinary income taxes, with the exception of non-qualified earnings distributions.
Oops, just saw the line where you stated it. Missed it the first time through.
Nice expansion on the Roth IRA withdrawal rules!
The reasons listed above is why I will be using a Roth IRA as an emergency fund in addition to a retirement vehicle!
Why us it as an emergency fund? Because I don’t ever expect to use it, but if I have to, it’s there!
I am considering a home purchase, and it’s not my first home, so I do not have a qualified distribution.
However, I can withdraw any amount no greater than my contributions, and I am fine, right?
I really don’t want to be hit with a tax or penalty, and the rules are confusing. Most web sites I’ve seen talking about Roth IRA’s only talk about withdrawals in terms of the earnings…
Depends what you mean by ‘fine’. If you withdraw money from your IRA, you will forever lose all tax free earning potential for that money. It will no longer be growing tax free or invested for you in your retirement accounts.
I would seriously urge you to consider taking the time to save the money regularly before you purchase your home. The home market isn’t exactly going to run away from you in the meantime these days. Robbing from your retirement savings to purchase your home is something I really wish you would reconsider.
However, since I’m think you’re only asking from a tax perspective, the answer is yes:
“Are Distributions Taxable?
You do not include in your gross income qualified distributions or distributions that are a return of your regular contributions from your Roth IRA(s). You also do not include distributions from your Roth IRA that you roll over tax free into another Roth IRA. You may have to include part of other distributions in your income. See Ordering Rules for Distributions , later.”
Source: http://www.irs.gov/publications/p590/ch02.html#en_US_publink1000231057
These are great stuff. You guys are great. I am still not clear on one issue.
I think I read somewhere that you can withdraw from your Roth IRA before you 59.5 years old without paying either tax & penalty. but you have to withdraw equal amount for 5 years.
Here is the specifics:
The Roth IRA was open over 10 years ago – a rollover from an IRA & I never made any more contributions since.
Already took out the entire original amount of the rollover, so only gains left in the account.
Can I still withdraw (say $40k) each year for 5 years without both tax & penalty?
Or I have to pay regular income tax, but no 10% penalty.
Or I have to pay both tax & 10% penalty?
Thanks.
Tony, based on my understanding of the IRS Publication 590, you can make early withdrawals and avoid the 10% penalty (but you still have to pay income taxes) if the distributions are part of a series of substantially equal payments for a duration of a minimum of five years or until you reach age 59½, whichever is longer.
However, I am not 100% certain of the implications in your situation and I highly recommend contacting a financial planner or tax professional before making any withdrawals from your Roth IRA.
Yup, the term is “substantially equal periodic payments” (SEPP). If you google that, you’ll find a lot about the pros and cons.
My question regarding withdrawals from the Roth is this: I was told that one can withdraw money from their Roth if it is only the basis of what they put into it…not to include the interest accrued. …and that it has be more than 5 years ago. So, any money that I put into my Roth starting before July 2005 is fair game for me to withdraw (only the basis). Is this correct?
Here’s the answer straight from the horse’s mouth:
http://www.irs.gov/publications/p590/ch02.html#en_US_publink1000231057
(the answer to your question is right at the beginning of that section (‘Are Distributions Taxable’) – just read up to and including the figure, i’m not sending you to something that you have to read pages and pages of)
One question I have is if a client has multiple Roth IRAs at different financial institutions, when taking a distribution, is it correct that they should be taking into consideration all contracts for determining what would be taxable. For example Joe has made $5000 contributions to 4 Roth IRAs to diversify his investments. Joe is under age 591/2 therefore not qualifying for a distribution under current IRS rules. He decides in year three to take a $6000 distribution out of Roth IRA 1 that is now worth $7000. Even though Roth IRA 1 has a gain, because he has three other Roth IRAs with contributions totaling $15,000 Joe would not experience any taxable income for this distribution. It is up to Joe to maintain a papertrail of the contributions he has made to the IRS and file an 8606 form when filing his tax return. It would be appreciated if you could let me know your thoughts regarding my interpretation.
Thanks.
Marcy, I am not a professional financial or tax advisor, so I will have to defer this question for a pro.
On a side note, I am not sure why he had to open IRAs at several different institutions to achieve diversification unless those particular investments were only available with the specific financial institutions he uses. It would probably be easier to manage the investments if they were housed in fewer locations. It might not be a bad idea to take a closer look at the investments he has to determine if there is a single investment firm that offers the right mix of diversified investments for his needs. Most brokerage firms offer a competitive selection of investment opportunities, so he may be able to roll over several IRAs into one or two IRAs, which could make some things much easier.
Again, it’s all laid out in IRS Publication 590. There’s no need for any interpretation.
While I believe you’re on the right track (counting multiple same-type IRAs as one), I didn’t follow all the particulars and I don’t know if the rules vary depending on the type of IRA or other details.
But I know exactly where you can go to find out:
http://www.irs.gov/publications/p590/