Roth IRA Withdrawals: Read This First

They can seem like an easy fix, but beware of penalties and taxes

So often, it seems, a little sacrifice in the short term leads to a more fruitful outcome down the road. The Roth individual retirement account (Roth IRA) is a perfect example.

Unlike money saved through its older cousin, the traditional IRA, the funds that you put into Roth accounts are not subject to income tax. But you must meet certain requirements to withdraw tax-free funds once you’re age 59½ or older—without having to worry about required minimum distributions (RMDs). What’s more, you can withdraw your contributions (not the earnings on those contributions) at any time, for any reason.

It’s a great solution for investors who seek tax diversification or for younger investors who expect to be in a higher bracket later in life. You’re paying a low tax now, so you don’t have to pay a steeper marginal rate in the future. And the ability to withdraw contributions makes the Roth particularly flexible—a sort of backup emergency fund, though it’s unwise to use it that way except in dire circumstances.

Understanding the rules is absolutely imperative. Take the wrong type of money out of your Roth account too early, and you could face income taxes and a 10% penalty on any earnings that you withdraw.

Key Takeaways

  • Roth individual retirement accounts (Roth IRAs) accumulate after-tax dollars and grow tax-exempt for retirement savers.
  • Withdrawing funds early from a Roth can result in a 10% penalty, but only if those withdrawals are from earnings, not from the money contributed.
  • A Roth IRA also must be owned for at least five full years before any withdrawals of earnings can be made penalty-free, regardless of age.

Avoiding Taxes and Penalties

The ability to enjoy completely tax-free withdrawals generally comes down to two requirements: You have to be age 59½ or older, and you must have owned the account for at least five years.

The Internal Revenue Service (IRS) outlines the specific requirements for taking qualified distributions from a Roth IRA. If you reach the required age but have held the IRA for less than five years, you still avoid the 10% penalty but will need to pay income taxes on any earnings pulled out of your account (you already paid income taxes on the money that you initially put into the Roth, so withdrawals of the contribution amount are always tax-free).

Say that you opened a Roth account at age 58 with a $5,000 contribution and earned $1,000 in gains over a two-year period. At age 60, you decide to withdraw all that money, which you can do penalty-free. But since you only owned the IRA for only two years, you still face income taxes on the $1,000 in earnings. So, to maximize your return, you should wait until you meet both the age and ownership conditions.

What Happens When You’re Under Age 59½?

Where you really get into trouble is when you pull earnings money out of your account before age 59½. Suddenly, you’re on the hook for both income taxes and the penalty—unless you qualify for an exemption.

Those under age 59½ who have owned the IRA for less than five years can withdraw earnings free of penalty—but not free of income tax—if they fall into one of the following categories:

  • You become permanently disabled or deceased (with your beneficiaries withdrawing the money if you have passed away).
  • You use the money to purchase your first home (subject to a $10,000 lifetime maximum).
  • You use the funds to pay for qualified education expenses.
  • You take a withdrawal to pay for unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI).
  • You inherit funds from a deceased IRA owner.
  • You use the money to pay an IRS levy on a qualified plan.
  • The money can be classified as a qualified reservist distribution.
  • You receive benefits as part of an annuity, and you make the distribution in substantially equal periodic payments (SEPPs).

SEPPs are fixed withdrawal amounts that you make over your expected lifespan (yes, the IRS has a form that will show you exactly how long that is). As you might guess, it requires doing a little math.

If you’re not yet 59½ years old but have had the Roth IRA for at least five years, you may be able to withdraw earnings tax- and penalty-free. But the list of exemptions is shorter. You qualify if:

  • You become permanently disabled.
  • You use the money to purchase your first home (subject to a $10,000 lifetime maximum).
  • The money goes to your beneficiary or estate after your death.

Figure 1. Pulling money out of your Roth IRA early can trigger income taxes and/or a 10% penalty.

Tax and penalty consequences when withdrawing funds from a Roth IRA.

How to Calculate Earnings

Of course, if you are making an unqualified withdrawal, this raises an important question: How much of the money that you pull out is considered a contribution (which can always be taken out tax free), and how much is earnings?

Fortunately, the answer is fairly straightforward. The IRS has an ordering system for withdrawals, as follows:

  1. Regular contributions
  2. Taxable conversion amounts from a traditional IRA (contributions for which the account owner paid income taxes during the conversion)
  3. Nontaxable conversion amounts (no tax deduction was allowed when making the initial IRA contribution)
  4. Earnings

Any funds from an IRA conversion come out on a first-in, first-out basis. This means that the earliest contributions are the ones that you withdraw first.

Let’s say that the account owner is a 30-year-old who opened a Roth IRA four years ago with a $25,000 contribution. Two years ago, she took $5,000 from a traditional IRA that she had and converted it into a Roth (paying income tax in the process). She also has $15,000 of investment gains in the account.

Now she wants to withdraw $40,000 to buy her first home. The IRS ordering system dictates which of those categories she’ll tap first. This means that her withdrawal includes the entirety of her $25,000 contribution as well as her $5,000 rollover the following year. Remember, she has already paid income tax on these contributions, so she doesn’t have to do so again.

To arrive at $40,000, she also has to pull out $10,000 of earnings. Because this falls within the lifetime limit for a first-home purchase exemption, she avoids the penalty—but not the taxes—on this amount. The remaining $5,000 in her account is classified as earnings.

What Happens if You Pull Money Out of a Roth Individual Retirement Account (Roth IRA) Early?

If you make a distribution from a Roth individual retirement account (Roth IRA) before age 59½, the earnings are typically subject to taxes and a 10% penalty (the withdrawal of contributions are tax-free). However, you may be able to avoid the penalty on earnings if you use the money for, say, a first-time home purchase or higher education expenses. You can avoid the penalty and tax on earnings for those special circumstances if you have owned the account for at least five years.

What Is Considered an Early Withdrawal From a Roth IRA?

You can withdraw contributions at any time from a Roth IRA, since you already paid taxes before putting money into the account. However, you typically can’t withdraw earnings in your account tax- and penalty-free until you’ve reached age 59½ and have owned the account for at least five years. There are some special circumstances that let you skirt taxes and penalties, though, such as the purchase of a first home.

How Much of an Early Roth IRA Withdrawal Is Considered Earnings?

The Internal Revenue Service (IRS) has an ordering system for withdrawals. The first dollars that come out of your account are regular contributions, followed by taxable and then nontaxable conversion amounts. Any remaining funds that are pulled out are considered earnings.

The Bottom Line

When money is running a little short, it can be tempting to look at your Roth IRA as a quick fix. But before you do, be sure that you know the rules. Pulling money out too early can sometimes trigger income taxes on your earnings—not to mention a 10% penalty. This means that an imprudent withdrawal can mean squandering the tremendous advantages that a Roth affords.

Article Sources

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  1. Internal Revenue Service. “Traditional and Roth IRAs.”

  2. Internal Revenue Service. "Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs)," Pages 31-32.

  3. Internal Revenue Service. "Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs)," Pages 25-28, 31-32.

  4. Internal Revenue Service. “Internal Revenue Bulletin No. 2002-42,” Pages 710–711.

  5. Internal Revenue Service. "Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs)," Pages 31.

  6. Internal Revenue Service. "Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs)," Pages 32-33.

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