Roth IRA Early Withdrawal Rules For After Tax Contributions, Traditional IRA Conversions and Investment Earnings

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A Roth IRA can provide a great way to build up savings for retirement. These accounts allow funds to grow on a tax-free basis. And, provided that the account owner meets just a few requirements, all the money contributed and earned in a Roth IRA account may also be withdrawn without taxation at retirement.

Oftentimes, however, individuals may need their Roth IRA funds prior to retirement and/or turning age 59 ½. In these cases, the money inside of a Roth IRA account may be withdrawn, but there is the possibility of tax consequences, as well as an additional 10% IRS penalty. These consequences will be dependent in large part upon how the funds were originally contributed, as well as how long ago the money was deposited into the account.

There are three primary categorizations of funds in a Roth IRA account which drive what taxes or penalties you may pay if making early withdrawals.

  • Personal after-tax contributions
  • Contributions that are transferred in from a traditional IRA account
  • Earnings from within the Roth IRA account

This is also the order in which the IRS considers Roth IRA withdrawals to be made. By withdrawing funds in this order, the taxable portion of Roth IRA funds will essentially be held off until the end – making is easier for account owners to make penalty-free withdrawals.

However, depending upon when exactly the money comes out of the account, each of these categories has their own rules regarding potential tax and/or IRS penalties that may be imposed upon the funds.

Personal After-Tax Contributions

Unlike traditional IRAs where account holders may be able to make pre-tax contributions, those who make deposits into a Roth IRA will typically be taxed on deposited funds before they go into the account.

Because personal individual contributions to Roth IRAs are made with after-tax dollars, an account holder is allowed to withdraw these funds at any time without tax consequences on these funds, as well as without an IRS penalty – regardless of whether or not they have reached age 59 ½ .

Once the total amount of deposited funds has been withdrawn, however, the remainder of the account balance is considered to be earnings. In this case, should the Roth IRA owner continue to make withdrawals from the account, these dollars would generally be taxed as ordinary income – and if the individual is not yet age 59 ½, they will typically also be charged with an additional IRS penalty of 10% of the amount that is withdrawn.

Roth Contributions from Traditional IRA Accounts

In many instances, individuals have moved funds from a traditional IRA to a Roth IRA account – and in some cases, a Roth IRA account holder may have transferred funds from more than one traditional IRA account.

Here, each of the individual conversions will have its own five year holding period requirement that begins on the first day of the tax year for the particular conversion. What this means is that any funds that were moved to a Roth IRA account five years ago or longer may be withdrawn tax-free, as well as without the additional 10% IRS early withdrawal penalty.

If, however, the funds were moved into one’s Roth IRA less than five years ago, withdrawals may be taken from the account without taxation. However, the funds that are withdrawn will still be subject to the 10% IRS penalty for early IRA withdrawals – even if the account owner is over the age of 59 ½.

Earnings from Within the Roth IRA Account

The earnings in a Roth IRA account can typically be withdrawn both tax and penalty-free after the account holder turns age 59 ½ – provided that the individual meets the 5-year rule. This means that as long as it has been at least five years since the Roth IRA owner originally opened and contributed to their account, they will have this privilege – regardless of the account owner’s age when he or she first opened the account.

As an example, if an individual originally opens and funds their Roth IRA at age 58, they must wait until they are at least age 63 before they will be allowed to make penalty-free withdrawals of the earnings on that particular portion of their account contributions.

If a Roth IRA owner has not yet reached age 59 ½, there are some situations where the 10% IRS penalty will be waived upon the withdrawal of funds – even if those funds represent earnings in the account. Some of these exceptions may include:

  • The funds are needed to pay the account holder’s unreimbursed medical expenses that exceed 7.5% of their adjusted gross income.
  • The funds will be used towards a first-time home purchase. (Roth IRA account holders who take advantage of this exception are only allowed to withdraw a maximum of $10,000 over their lifetime for this purpose).
  • The account owner is using the money to pay premiums on his or her health insurance after they have lost their job.
  • The distribution of funds is considered to be qualified disaster recovery assistance.
  • The withdrawn funds do not exceed the amount of qualified higher education expenses for either the account holder or his or her eligible family members.
  • The distributions are considered to be part of a series of substantially equal payments, such as in the case of a retirement annuity. (These funds must continue for a period of at least five years, or until the account holder reaches age 59 ½ – whichever is longer).

The Bottom Line

Although Roth IRAs offer a great deal of flexibility in terms of making withdrawals, it is important to remember that the primary purpose of these funds is for long-term retirement needs.

With this in mind, taking funds from the account early will likely lessen the total amount of dollars that can be used in the future. Therefore, prior to taking any Roth IRA withdrawal, it is essential to look at all angles of how withdrawing the funds can affect both short- and long-term financial needs.

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{ 2 comments… read them below or add one }

RampantRedsFan February 2, 2013 at 5:45 pm

Frank,

The answer to your question is yes.

You have a maximum annual contribution to your 401k of somewhere in the neighborhood of 16-21k depending on age, and you can contribute to a Roth up to 5500 + 1k for 2013 since you are older than 50 (5k + 1k for 2012). The only thing you need to watch out for are income limits. I know it is a little under 100k AGI for single, and I think around 160k AGI for filing jointly.

Matt

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frank January 28, 2013 at 7:04 pm

If I am currently contributiing to a 401K, can I open up and continuously deposit money into a ROTH IRA? I want to open up a schwab brokerage account and make stock investments and use my earnings as tax free distributions at age 60.

I am currently 54 years old

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