Roth IRA Withdrawal Rules, Options, and Penalties

Roth IRA Withdrawal Rules, Options, PenaltiesInvestors love the Roth IRA for the potential tax-free income at retirement.

Who doesn’t like skimming the government from paying more tax?

The rules of the Roth IRA make it a great saving tool because you have more flexibility when you can withdraw the funds.

Retiring early or an unexpected emergency make the Roth IRA the king of retirement tools to use because you have access to the money.

If you ever do consider taking money out of your Roth IRA, you better know all the withdraw rules to avoid paying an unnecessary penalty.

“Whether you have an accounting degree or not, it’s easy to understand how a Roth IRA works.”

Don’t have an IRA yet? You can Scottrade. Don’t miss the IRA deadline. Get your contributions in before it’s too late!

Roth IRA Contributions are Cool, but Lay off Your Earnings.

I amazed the number of people that don’t know that you can withdraw your Roth IRA Contributions at any time without tax or penalty.  In layman terms: You can get what you put in.  With your earnings, that’s another story.  There is a certain order that has to come out to make sure you follow the Roth IRA rules correctly.

Roth IRA Ordering Rules for Distributions:

    1. First wave that comes out our contributions.  I stated that above and will state it again:  Roth IRA contributions come out first.  There is no tax or penalty that is applied. What about the five year rule?  Nope.  Not applicable.  You can take your money with no worries.
  • The next wave according to the IRS rules are the conversions and rollover contributions to your Roth. To understand what comes out first we have to break out a familiar accounting term: FIFO.  This stands for first, in first out.  This means that a conversion that occurred in 2004 would come out first before a conversion made in 2007.  Pretty simple, right?  Keep in mind that the taxable portion will come out first in the event there is any non-taxable amount included.  The IRS practices FIFO, too; but more in how they get paid.
  • The last part is the earnings. Finally, earnings accrued by a Roth IRA are distributed. So in other words, rarely withdraw your regular contribution and whatnot for your tax, but if your Roth has realized earnings from contributions, the earnings will be subject to income tax, they are withdrawn.

What  Makes Your Roth IRA Withdrawal a Qualified Distribution?

This is where the Roth IRA rules can get tricky.  If you have owned the Roth less than five years even if you are 59 1/2, the earnings will still be hit with taxes and the 10% penalty.  Greater than five years, then you are in the clear.  You then are allowed to take a “qualified distribution” from your Roth and throw your nose up to the IRS because you don’t have to give them a dime of it.  Enjoy that moment when it comes! The same five year rule applies to Roth IRA conversions, too.  The added nuance with conversions is that each conversion starts a brand new five year clock.  Remember: after 59 1/2 this is just the earnings.  Contributions are yours whenever you want them.

Roth IRA Five Year Rule For a Qualified Withdrawal

Roth IRA Five Year Rule Creative Commons License photo credit: Môsieur J. [version 3.0b] In assessing the five year holding rule, the time starts on January 1st of the tax year of you make your first contribution.  Even if you waited until the deadline of April 15th of the following year to make the contribution, its retroactive the January 1.

Converting More Than One Roth IRA

Remember if you are planning on converting more than one IRA in 2010, the IRS will aggregate them all together. This includes all traditional IRA’s and non-deductible IRA’s.  The only thing excluded are 401k’s, 403b’s and 457′s.  If you do convert these in the same tax year after you converted, they will be added to the total.

Jacob has a traditional IRA of $12,000, which he has only contributed $6,000 to. His income now exceeds the Roth IRA phaseoutlimits and wants to use a non-deductble IRA and immediately convert it. When he contributes $5,000 to the IRA and immediately converts, he will have to include $11,390 to her income (67% of $17,000) instead of just the $5,000 of the IRA that maybe he was hoping.

Jeff Rose, a Certified Financial Planner in Illinois who authors the blog Good Financial Cents has an excellent post on the Roth IRA conversion tax rules.  I encourage you to check it out.

Seek Advice

If, for any reason, you have to take a distribution or trying to calculate the tax on a conversion, seek the counsel of a tax professional.  It can get tricky and it’s important to have someone who knows the rules. Need to Open an IRA? Check out Scottrade account. Don’t delay – fully fund your IRA today!

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