When considering a Roth IRA distribution, proceed carefully. Every Roth IRA withdrawal means the sacrifice of important benefits from previous Roth IRA contributions. Remember, all of the investment growth within your regular IRA is tax-free.
Roth IRA Withdrawal Rules
All qualified distributions from Roth IRAs are tax-free. To be a qualified Roth IRA distribution, the withdrawal must satisfy the Five Year Rule. In addition, to be tax-free, the distribution must occur:
- On or after reaching age 59 ½
- At or after your death (and the account is paid to your beneficiary)
- Due to your disability
- In conjunction with a qualified “first-home” purchase (a withdrawal of up to $10,000)
Remember, to be a qualified distribution and therefore tax-free, your Roth IRA withdrawal must satisfy both the Five Year Rule and meet at least one of the conditions in the list above.
Nonqualified Roth IRA Distributions
Any distribution that does not pass both tests is a nonqualified distribution and may be subject to income tax. The size of the distribution, the amount of any previous distributions, and the amount of original contributions determine if and to what extent a nonqualified distribution is taxable.
Ordering Rules for Nonqualified Roth Distributions
Roth distributions are first considered made from your contributions. Once the total of all Roth distributions exceeds your contributions, distributions next come from non-conversion contributions, followed by conversion contributions, and, finally, from earnings. The ordering of nonqualified distributions matters because it determines if you have to pay tax on any given distribution.
Penalty Tax on Early Nonqualified Roth Distributions
If tax is due on any Roth IRA withdrawal, the 10% penalty tax will also be assessed unless it meets a specific exception, such as the following:
- You're at least 59 ½
- The distribution is one of a series of substantially equal periodic payments
- You withdraw an amount less than is allowable as a medical expense deduction
- The distribution is used to pay medical insurance premiums – must be related to receiving more than 12 weeks of unemployment compensation
- Using the distribution to pay for the qualified higher education expenses for the IRA owner or certain family members.
Roth IRA Distribution Tax Treatment Examples
Here are two common examples of nonqualified distributions and how they are treated for tax purposes.
Example A:
Meredith contributes $5,000 to her Roth IRA during 2003. In 2009, she closes her account which is then valued at $7,000. Meredith is 45 years old and is neither disabled nor qualifies for any early distribution exceptions. She will pay ordinary income taxes and a 10% penalty on $2,000 of earnings. If she is in the 25% tax bracket, the total owed as a result of the nonqualified distribution is $700.
Tax: 25% of $2,000 = $500
Penalty: 10% of $2,000 = $200
Tax + Penalty: $500 + $200 = $700
Example B:
Jon also contributes $5,000 to his Roth IRA in 2003. In 2009, when his account balance is also worth $7,000, he withdraws $4,000. Like Meredith, Jon is also 45 years old and is neither disabled nor qualifies for any early distribution exceptions. Since the $4,000 nonqualified distribution is less than Jon's $5,000 original contribution, none of the distribution is taxable nor is it subject to any penalty.
Additional Early IRA Withdrawal Considerations
In addition to potential penalties and taxes due upon an early IRA withdrawal, you lose all possible future investment growth of your money in your retirement plan. Furthermore, since there are annual limits to the amount you can contribute to a Roth IRA, you can’t make up a previous withdrawal later, even when you are on more solid financial ground.
No Required Minimum Distributions From Roth IRAs
No Required Minimum Distributions (RMD) are required from your Roth IRA, a key estate planning advantage over 401K plans and regular IRAs.
