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When you consider a withdrawal from your Roth IRA, it’s important to understand the penalties and tax implications involved. If you take money out too soon, you could face a 10% penalty on earnings, along with possible taxes. Knowing the rules about contributions and earnings can help you plan withdrawals more effectively.
Roth IRA Funding Sources and Implications
You can fund a Roth IRA through one or more sources, including contributions, conversions, and rollovers from a qualified retirement plan. In addition, the Roth IRA balance presumably contains earnings from investment growth. (In this article, I will refer to conversions and rollovers as simply conversions.) It is important to make the distinction between these sources because the tax treatment and potential tax penalty for Roth distributions are impacted by the source of the funds you’re withdrawing.
You can withdraw your contributions at any time without incurring taxes or penalties, but the same may not be true for conversions and earnings. Withdrawing converted funds or earnings of your investments is subject to strict rules that, if overlooked, can cost you significantly. Understanding these regulations can help you avoid unnecessary surprises and make more informed financial decisions.—
Key Takeaways
- You can withdraw contributions anytime without penalties.
- Early withdrawal of converted funds and earnings can lead to taxes and a 10% penalty.
- If it has been five years from the beginning of year in which you opened and contributed to your Roth IRA and you’ve reached age 59 1/2, you are not subject to any taxes or penalties associated with any withdrawals.
- Understanding the rules helps you minimize costs and maximize benefits.
Basics of Roth IRA Withdrawals
When you’re considering withdrawals from your Roth IRA, it’s essential for you to understand the types of distributions and the rules surrounding them. Each aspect has specific requirements that can impact your finances significantly.
Qualified Distributions
To make a qualifying distribution, or withdrawal, from your Roth IRA without paying taxes or a penalty, your account must have been open for at least five years from the beginning of year in which you contributed to it; let’s call this 5-year Rule #1. In addition, you must meet one of the following criteria associated with the distribution:
- You were at least 59 1/2 years old.
- The distribution was to support your disability.
- Following your death, a distribution was a payment to your estate or beneficiary.
- You used the distribution for a first-time home purchase, up to a $10,000 limit.
Non-Qualified Distributions
If the criteria are not met for Qualified Distribution as described in Qualifed Distributions, your withdrawals are considered Non-Qualified. In this case, part of the withdrawal might be subject to taxes, a 10% tax penalty, or both. This depends on the the way the IRS defines the order in which contributions, conversions, and earnings are withdrawn from a Roth account:
- First are regular contributions.
- Second are conversions (and rollovers), starting with the oldest conversion on a first-in, first-out basis. Keep in mind that some conversions might have been taxable or non-taxable; the IRS considers the withdrawing of taxable conversions as occurring before non-taxable conversions.
- Third are earnings on contributions.
Withdrawing Regular Contributions
If you withdraw a regular contribution, it is not subject to taxes or penalties because they have been made with after-tax funds.
Withdrawing Conversions
If you withdraw a conversion that has already been taxed after the conversion was made, it is not taxed again as income. However, it may be subject to a 10% penalty depending on what I’ll call 5-year Rule #2. This rule is defined differently than 5-year Rule #1 as described in Qualifed Distributions. The 5-year Rule #2 defines a 5-year window that starts on the first day of the tax year in which you make a conversion and ends after five years.
For example, if you made a conversion in December 2020, the 5-year window starts on January 1, 2020 and ends on January 1, 2025. If you withdraw conversions within this 5-year window, you must pay a 10% tax on the withdrawn funds unless you met one of the many exceptions the IRS provides. One of the notable exceptions is if you have reached age 59 1/2. For a complete list of exceptions, see Additional Tax on Early Distributions ↗.
Withdrawing Earnings
If you withdraw earnings that are considered non-qualified distributions, they are treated as income and subject to taxes. The 10% tax penalty is also applied to earnings unless one of the exceptions that applies to withdrawing conversions also applies to earnings (see Additional Tax on Early Distributions ↗).
Strategies to Minimize Penalties and Taxes
You can take specific actions to minimize potential taxes and penalties on Roth IRA withdrawals. To do so, you must keep good records of your Roth IRA contributions and conversions, including the amount and the dates of these transactions. Remember, the IRS considers the withdrawal order to be contributions, conversions, and finally earnings. If your withdrawals are less than your total contributions, you will not be subject to taxes or a penalty.
After you’ve withdrawn all of your contributions, aim to withdraw your conversions after the 5-year window for each conversion has passed. Again, you pay no taxes or a penalty.
Finally, after you’ve withdrawn all contributions and conversions, your Roth IRA balance contains only earnings. (Of course, it’s possible that you’ll be left with no earnings if your investments have a net loss, but I hope you’re in the minority!) Aim to withdraw earnings only after they’re considered qualified distributions to avoid both taxes and penalties.
Summary
By understanding the rules for Roth IRA withdrawals, you can maximize your retirement savings while minimizing taxes and penalties. With careful planning, you’ll be able to enjoy the full benefits of your Roth IRA during your retirement years.
For more information on Roth conversions, see Delaying Social Security with Roth Conversions: A Step-by-Step Guide.
And remember, it’s always a great idea to chat with your financial or tax advisor to make sure your decisions are right on track and aligned with the latest guidelines and laws.