Aside from employer-sponsored retirement plans, individual retirement accounts (IRAs) are perhaps one of the best retirement savings tools available. IRAs provide tax-deferred growth on invested assets among other benefits depending on the type of IRA. Deductible traditional IRAs offer tax deductions on contributions as well as the tax-deferred growth that allows these accounts to take full advantage of compounding interest. Withdrawals from traditional IRAs are taxed as regular income, and the tax rates are based on your tax bracket for the year in which you make the withdrawal.
Roth IRAs, on the other hand, do not offer tax deductions on contributions, as contributions to the account must be after-tax. But in exchange, Roth IRA account owners are not only offered the same tax-deferred growth on their assets, but also tax-free distributions and withdrawals. Here's how Roth IRA withdrawals work, including some rules and regulations.
Tax-Free Qualified Distribution Roth IRA Withdrawals
Provided you have reached at least the age of 59 1/2 and have had your Roth IRA account open for at least five years, all of your Roth IRA withdrawal is tax-free. In fact, it will be considered a qualified distribution. Though this combination of criteria is perhaps the most common for taking a qualified distribution from a Roth IRA, there are several other scenarios in which withdrawals are considered qualified and, therefore, are tax-free if you're under age 59 1/2 and meet the five-year requirement:
- If you are disabled
- If the withdrawal is paid out to your beneficiary or your estate after your death
- If the withdrawal meets the IRS "first home" requirements (up to a $10,000 lifetime maximum)
Such tax-free income in retirement is among the biggest benefits of a Roth IRA, but unlike traditional IRAs, you need not wait until retirement to withdraw your assets penalty and tax-free.
Some types of withdrawals, though not qualified distributions, are exceptions to the 10% early distribution penalty. Non-qualified distributions associated with these exceptions are penalty free, but earnings remain taxable. Penalty-free exceptions include:
- If the withdrawal is used to pay for health insurance while unemployed or unreimbursed medical expenses that are more than 7.5% of your adjusted gross income for the year.
- If the distribution is made in substantially equal periodic payments (see IRS Rule 72(t)).
Tax-Free Return of Basis Roth IRA Withdrawals
Since no Roth IRA contribution is ever tax deductible like a traditional IRA, most Roth IRA withdrawals will not be taxed. There is no tax due on any Roth IRA withdrawal if the total amount you withdraw is less than the amount you have previously contributed no matter your age. For example, if over several years your annual contributions total $20,000 and you subsequently withdraw $5,000, none of your withdrawal will be taxable as it is considered a return of your original contribution. In tax jargon, a withdrawal of previous contributions is considered a "return of basis."
That said, there are a few scenarios in which you may be assessed an early distribution tax as a penalty on a Roth IRA withdrawal.
Penalized Roth IRA Withdrawals
Using the same example scenario as above, if you were to withdraw more than the $20,000 you had already contributed to your Roth IRA, meaning that you were also withdrawing earnings prior to reaching age 59 1/2, part of your withdrawal would be subject to taxes and a 10% tax for early distributions. The same would be said for any Roth IRA withdrawals above your basis (contributions) within the first five years of contributing to the account. This rule is colloquially known as the five-year rule. The Roth five-year rule is not as straightforward as you might think, since satisfying the five-year rule can actually take less than five years, according to the IRS's definition. To make matters more complicated, Roth IRA conversion assets follow their own separate timeline for the five-year rule.
If Roth IRA funds are added via a Roth IRA conversion, these funds specifically must meet the five-year rule themselves. As such, if you convert a Roth IRA and then take some of those converted monies the next year, your withdrawal would be taxable.
The 10% Early Distribution Penalty
In addition to the regular income tax, a 10% early distribution penalty is generally assessed on distributions that are made if the account holder has not yet reached age 59 1/2. However, the 10% early distribution penalty will only be assessed on withdrawals that are taxable. As such, any withdrawals that are returns of basis aren’t subject to the early distribution penalty, even if the taxpayer is under 59 1/2.