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 IRA is a perfect example.

Unlike money saved through its older cousin, the traditional IRA, the funds you put into Roth accounts are subject to income tax. But as long as you meet the requirements, you can pull out money completely tax-free once you’re 59½ or older—all without having to worry about required minimum distributions (RMDs).

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.

But understanding the rules is absolutely imperative. Take 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 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 on earnings and not money contributed.
  • A Roth IRA must also be owned for at least five full years before any withdrawals 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 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 you will need to pay income taxes on any earnings pulled out of your account (you already paid income taxes on the money you initially put into the Roth, so withdrawals of the contribution amount are always tax-free).

Say you opened a Roth account at age 58 with a $5,000 contribution and earned $1,000 in gains over a two-year period. If at age 60, you decide to withdraw all that money, you can do so penalty-free. But since you only owned the IRA for two years, you still face income taxes on the $1,000 in earnings. So in order to maximize your return, it behooves you to 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—that is, unless you qualify for an exemption.

Those under 59½ who have owned the IRA for less than five years can withdraw earnings penalty-free—but not income tax-free—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.
  • 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're receiving benefits as part of an annuity, and you make the distribution in substantially equal periodic payments.

Substantially equal periodic payments (SEPP) are fixed withdrawal amounts that you make over your expected lifespan (yes, the IRS has a form that’ll show you exactly how long that is). As you might guess, it requires doing a little math.

If you’re not yet 59½ years of age 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 account 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 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. Non-taxable 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. That means the earliest contributions are the ones that you withdraw first.

Let’s say 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 converted $5,000 from a traditional IRA she had 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. That means her withdrawal includes the entirety of her $25,000 contribution as well as her $5,000 rollover the following year. Remember, she’s already paid income tax on these contributions, so she doesn’t have to do so again.

In order 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.

The Bottom Line

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

Article Sources

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  2. Internal Revenue Service. "Designated Roth Accounts - Distributions." Accessed July 3, 2020.

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  6. Internal Revenue Service. "Publication 590-B: Distributions from Individual Retirement Arrangements," Page 31. Accessed July 3, 2020.