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 how Roth IRA withdrawal rules work. 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 principal (contributions) at any time. However, the earnings from your principal cannot normally be withdrawn under age 59½ without paying the 10% early withdrawal penalty. Earnings can generally be withdrawn without penalties after age 59½, provided you meet the 5 year rule.
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 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.
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.