It’s essential for any investor to learn the basics of Roth IRA withdrawal rules. Here’s a guide to help anyone interested in opening a Roth IRA account.
Roth IRA Withdrawal Rules | Navigating the Complex Regulations
What Is Roth IRA? A Roth IRA is a type of individual retirement account (IRA) that allows a person to set aside after-tax income limited to certain amounts each year.
Why You Need to Know the Roth IRA Withdrawal Rules
Regulations for Roth IRAs can be complex, and they become even more difficult to understand when one needs to use the money earlier than expected.
Even if you don’t need the money for an emergency, it’s important to understand the rules for withdrawing early. Doing so in the wrong manner may negate the tax benefits that a Roth IRA provides.
However, there is good news. A Roth IRA is more flexible than an employer-sponsored retirement plan and a Traditional IRA. As an account holder, if you fully understand Roth IRA withdrawal rules, you will also be able to better manage your account.
1. Roth IRA Contribution Limits
With an individual retirement account (IRA), there’s a limit on how much a person can contribute per tax year.
In 2018, the maximum contribution was $5,500. For 2019, it increased to $6,000.
If the account holder is over 50 years old, the catch-up contribution is an additional $1,000.
You can also withdraw these IRA contributions from your account at any time. The keyword here is “contributions.” Let’s say you added $100 into your Roth account monthly for three years. You will be able to withdraw the $3,600 in contributions without an early withdrawal penalty. This is because you already paid the taxes on them. In other words, you made the contributions using post-tax dollars.
2. Order of Withdrawal
A Roth IRA can grow through a variety of investments, such as stocks and mutual funds.
It can even be used in a self-directed Roth IRA. This type of IRA lets you put money in alternative investments, such as real estate and precious metals.
If you’re fortunate enough with your investments, you may earn a lot of money. However, with a Roth IRA, you cannot get your earnings quickly.
One of the Roth IRA withdrawal rules to keep in mind is the order of distribution. The first in line are non-taxable contributions. The account holder can withdraw this anytime whether it’s a qualified or a non-qualified distribution. A non-qualified distribution means the withdrawal doesn’t meet the criteria to be exempt from taxes and penalties.
After you have withdrawn your contributions, earnings are last. However, if the distribution is non-qualified, it can be subject to taxes and penalties.
The question is, when does it become a qualified distribution? This is where Roth IRA’s five-year rule comes into play.
3. The Five-Year Rule
You must have an account for five years before you get a qualified investment growth.
What happens if you withdraw the earnings before this period? If it’s an early withdrawal from IRA, you will need to pay taxes and a 10% withdrawal penalty on the gains you plan to deduct.
The five-year rule starts on January 1 of the year you made your initial contribution. It doesn’t matter what date in the year you first contributed.
Even if you start your Roth IRA on December 1, you get a free period of 11 months.
If you also want to withdraw qualified earnings, you must be at least 59.5 years old.
There are some exceptions to these rules. For example, you may be able to consider a hardship withdrawal if you develop a disability. Additionally, you can use up to $10,000 to buy your first home.
Another exception is if you pass away. In this case, your heirs can make distributions. If you made your initial contributions at age 57, your heirs have to wait 5 years from the contribution date to take out the earnings without any penalties.
4. Exceptions to the Five-Year Rule
Here is where the Roth IRA withdrawal rules can get tricky. Read and understand the fine print for non-qualified IRA distributions before deciding to withdraw from the IRA account.
Here are situations that qualify as exceptions:
- You have unreimbursed medical expenses that exceed 7.5% for 2017 or 2018 and 10% for years thereafter, according to their adjusted gross income (AGI).
- You need to pay medical insurance premiums after a job loss.
- The distribution is part of equal payments issued in a series of equal payments for at least five years or until you turn 59.5, whichever comes last.
- You need the money for disaster recovery.
- The Roth IRA distributions result from an IRS levy.
- The amount you get is less than the higher education expenses for yourself or a family member.
If you are 59 or under, you may be able to avoid penalties on those withdrawals, but please note, you will still be subject to taxes on them.
One of the important Roth IRA withdrawal rules involves buying your first home. Each IRA owner can remove up to a lifetime maximum of $10,000. This amount is not subject to taxes or penalties.
If you and your spouse or partner each have a Roth IRA, you can withdraw as much as $20,000 for use as a down payment on a first-time home.
5. Qualified Higher Education Expenses
You can also withdraw from the retirement account to pay higher education expenses. Then, you do not need to pay taxes or penalties.
You can use the funds for yourself, your spouse, your children, or even your grandchildren. Expenses that qualify include tuition, books, fees, and other associated costs such as room and board for students enrolled at least half-time.
Withdrawing your Roth IRA retirement funds for education expenses turns it into a tax-deferred college savings plan. Asset control stays with the owner of the investment.
There is also no income phase-out when you use this method of financing education.
Of course, you may still want to be careful when using Roth IRA contributions to pay for college expenses, as you will have less available for retirement.
The distributions also still count as untaxed income and you will need to include it in the following year’s Free Application for Federal Student Aid (FAFSA) form. Please note, this may affect your eligibility for need-based financial aid.
6. Withdrawal Rules for Roth IRA Conversion
When you decide to withdraw from your Roth IRA, the funds come out in a set order. If you choose to take out money early, the order rules will reduce any penalties or taxes you may have to pay.
As mentioned, first, these Roth IRA withdrawal rules apply to the money you contribute to your account.
You then get the funds from a Traditional IRA or rollover. The order of withdrawal is according to which money you put in first.
The same rule also applies to Roth conversions. Some people may confuse rollovers and conversions since they can sound the same.
A rollover is when you move your account from one company to another. Roth conversions, also known as backdoor IRA, are when you change a Traditional IRA to a Roth IRA.
There is a significant difference, though. In a Roth IRA conversion, the five-year rule applies on the date that you make the conversion.
This rule is in place to prevent account owners from avoiding paying taxes for their distributions.
In a Traditional IRA, you will pay taxes according to the marginal income tax rate since you use pre-tax dollars to fund it.
If you turn 59.5 years old before the five-year rule elapses, you may be able to avoid paying both taxes and penalties.
7. Required Minimum Distributions
For some IRAs, you must take a mandatory minimum distribution by a certain age, usually when you are 70.5 years old.
Roth IRAs are different, as they generally don’t require minimum distributions.
Account owners are free to leave their money in a Roth IRA and let it accumulate earnings for as long as they desire.
8. Roth IRA Withdrawal Rules after Age 59 1/2
What if you’re 59.5 years old to 70, and you don’t meet the five-year rule? In this case, you may have to pay taxes but not penalties. From age 70.5 and beyond, the Roth IRA withdrawal rules are the same.
9. Excess Contribution
Some people may make excess contributions to their Roth IRA. It may happen during the conversion or in the passage of time — they sometimes forget how much they already contributed to their account.
Don’t forget to download, save, or share this handy infographic for reference:
Watch this video about the Roth IRA withdrawal rules:
It’s not something to ignore, though, since there is a 6% excise tax for each year you keep the excess contribution.
Roth IRA withdrawal rules may change over time, and they may also be difficult to remember, so it’s always a good idea to consult a tax professional. Such individuals can help through the withdrawal process and they may also help out in different aspects of the retirement plan.
Do you have any questions about Roth IRA withdrawal rules? Let us know in the comments section below.
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Editor’s Note: This post was originally published on February 15, 2018, and has been updated for quality and relevancy.