Making a Roth IRA early withdrawal (before age 59 1/2) could be less painful than you think, and is usually a thriftier alternative to tapping other retirement accounts like a traditional IRA or company-sponsored retirement plan.
Exactly how much tax and/or penalty you’ll owe the IRS, if any, is determined by the IRS ordering rules for Roth IRAs (see IRS Pub 590-B). When you withdraw money from your account, the IRS considers it to be withdrawn in the following order:
Principal contributions previously made directly to your Roth IRA come out first. These funds are never subject to any tax or penalty, no matter when you take them out or how old you are.
That means you can withdraw an amount up to the total of your direct principal contributions you’ve made over the years -- without tax or penalty -- for any reason what-so-ever.
Let’s say Sally is 26 and has made $8,000 in direct Roth IRA contributions over the last three years. Her current account balance is $11,000. She could take out $8,000 tax and penalty free for making improvements on her home … buying a new boat … taking a Hawaiian vacation … or any other reason you can think of …
Of course, given a decent rate of return on that money until her current full retirement age, that $11,000 would turn into a huge wad of 100% tax free cash. Sally could then afford to buy a really big boat!
Any funds that were converted (and taxable at the time of conversion) from a pre-tax account like a traditional IRA or 401(k) come out next.
If you’re 59 ½ or older, there is no tax or penalty, regardless of when the converted money is withdrawn.
If you withdraw these funds within 5 years of the conversion and you’re under 59 ½, there is a 10% early withdrawal penalty assessed but no tax liability. Keep in mind if you converted funds in multiple calendar years, each year’s conversion has its own 5 year clock.
A Roth IRA early withdrawal after five years will face no tax or penalty, regardless of your age.
Any non-deductable traditional IRA contributions that are subsequently converted to a Roth IRA fall into this category. This type of contribution to a traditional IRA is made with after-tax money – no deduction was taken on the contribution – so no tax is owed at the time of conversion. No penalty is assessed either.
Earnings come out last. In order for earnings to be free of penalty, the withdrawal must be considered qualified, which means one or more of the following four events have happened:
1. You are 59 ½ or older
2. You are disabled
3. You’re dead (and the payment is made to your appointed beneficiary)
4. You’re withdrawing funds for the purpose of a of a “first time” Roth IRA home purchase
In order for earnings to be free of tax as well as penalty, the 5 year rule must be satisfied in addition to being deemed a “qualified” withdrawal. This is a different five year rule than the one for converted money. It states your very first Roth IRA must have been open for at least five years.
Example: You are 58 and open your first Roth IRA on June 30, 2014: The 5 year rule won’t be satisfied until January 1, 2019, and any funds considered earnings taken out before that time would be subject to ordinary income tax. A penalty would be accessed only on funds taken out before turning age 59 ½. The penalty on withdrawals would be waived once 59 ½ years is reached, but would be assessed on any funds taken out between ages 58-59 ½.
If you meet all those criteria, your earnings withdrawal is free of tax and penalty.
Complicating matters further are the exceptions to the 10% penalty when making a Roth IRA early withdrawal for one or more of the following reasons:
These exceptions don’t necessarily escape tax (see the above ordering rules), but are free of the 10% penalty. Got all that? Leave it to those whacky folks at the IRS…
Now that you know the Roth IRA early withdrawal rules and how best to tap your Roth IRA with minimal tax and/or penalty before 59 1/2, here are some reasons not to touch it!
That's reason enough not to do a Roth IRA early withdrawal, unless you've got a really good reason.