Roth IRAs are one of the many ways you can save for retirement. Their key benefit – you can withdraw funds in retirement without paying taxes on the distributions – has made them very popular among tax-savvy investors. Still, there are rules surrounding Roth IRA withdrawals that you need to know in order to avoid costly penalties. How your distributions are treated by the IRS depends on your age, how long you’ve held the account, and a number of other factors. Here’s what you need to know.
A financial advisor could help you create a financial plan for your retirement needs and goals.
Roth IRA Withdrawal Rules: Qualified vs. Non-Qualified Distributions
Before you take any distributions from your Roth IRA account, it’s important to know the difference between qualified and non-qualified Roth withdrawals. All qualified distributions are tax- and penalty-free.
To take qualified distributions, account holders must be at least 59.5 years old. Additionally, account holds must have held their Roth IRA for at least five years. This process starts on January 1 of the year the first contribution was made. After this time threshold, your funds are accessible with out penalties.
If you need to get at your funds before you meet these criteria, there’s good news: You can distribute your contributions at any time, for any reason. You will not be subject to any taxation or penalties on contributions alone. However, if you distribute any of your earnings, penalties may apply. So if you’ve contributed $5,000 to a Roth IRA and the balance has grown to $6,000, you can take out that initial $5,000 at any time without penalty. But you can’t touch that $1,000 until you hit 59.5 (and the five-year account mark), or you’ll be hit with penalties from the IRS. Specifically, non-qualified Roth distributions are subject to taxation on your earnings and a 10% tax penalty.
But there are some exceptions to this rule. If your distribution qualifies for an IRS exception, no penalties will apply. According to the IRS, here are the exceptions taxpayers may qualify for.
Unreimbursed Medical Expenses
Medical care costs can add up. Many taxpayers may face financial hardship when trying to afford the costs from a medial emergency. When you have medical expenses that are more than 7.5% of your adjusted gross income, you may be able to avoid distribution penalties.
You cannot take more than your deduction for medical expenses on your Schedule A. To verify the appropriate distribution amount, you can review your recent tax filings.
You are not required to itemize your deductions in order to take advantage of this exception.
Health Insurance Premiums
Affording your health insurance premiums is a challenge if you have recently lost your job. Since you need health care coverage, these payments are a necessity. The IRS allows account holders to take tax- and penalty-free distributions to cover medical insurance premiums.
As long as you are eligible, you can use your Roth IRA withdrawals to cover medical insurance premiums for you, your spouse, or your dependents. You will not be subject to the 10% penalty and earnings taxation as long as your withdrawals don’t exceed your payment amounts.
Inherited Roth IRAs
Provided the previous account holder has met the 5-year rule, all beneficiary’s distributions will not be subject to penalties or earning taxation. As a Roth IRA beneficiary, you have the option to take funds as a required minimum distribution over your life expectancy. You can also choose to withdraw funds after December 31 of the fifth year after the account holder passes away.
A word of caution: If you do not withdraw the funds before the date mentioned above or establish a required minimum distribution, you could face a 50% excise tax on the remaining account balance.
Purchase of Your First Home
If you need help paying for a down payment for your first home, it’s possible you can use money from your Roth. Even if you are under 59.5, you may be able to use your withdrawals to pay for the cost of building, buying or reconstructing your first home.
To qualify for the first-homebuyer distribution, you must use your funds to pay the qualified acquisition costs. Keep in mind, the total distribution amount may not exceed $10,000. If you and your spouse are first-time home buyers, you may be able to withdraw $10,000 from each of your accounts.
Permanent Disability
Disability can put a wrench into your retirement savings. If you discover you’re unable to work due to a disability, you may need to tap into your savings.
You are considered disabled if you can prove that you cannot partake in work activity. Your lack of participation can be caused by your physical or mental health. A physician must determine that your condition will continue for an indefinite duration of time or may result in death.
Higher Education Expenses
College can be expensive. Some pre-retirees may need additional dollars to fund education expenses. Luckily, if you have contributed to a Roth IRA, you can use your account to pay for college costs.
The IRS lets account holders take tax- and penalty-free distributions to pay for higher education expenses. You can use these funds to pay for higher education expenses for you, your spouse, your children or grandchildren. These distributions can be used to pay for books, tuition, fees, supplies and more.
However, all higher education expenses must meet certain qualifications. Also, higher education expenses won’t qualify unless they’re from an eligible educational institution. Keep in mind, your Roth withdrawals can’t exceed the cost of your qualified higher education expenses. If they do, you are subject to earnings taxation and a 10% penalty.
Qualified Reservist Withdrawals
Any request for active duty can potentially derail your finances. If you run in to financial distress, taking Roth distributions is a potential solution.
Members of reserve components (Army Reserve, Marine Corps Reserve, Naval Reserve, etc.) who are called to active duty can take tax- and penalty-free withdrawals. To qualify, your active duty should exceed 179 days or be for an indefinite amount of time.
Subsequent Payments
If you are receiving a series of equal recurring payments, you can make a one-time switch to the required minimum distribution method at any time. You can make this switch without incurring the additional tax. Although, once you make this change, you must follow the required minimum distribution method in all subsequent years.
How to Establish a Roth IRA Account
Now that you understand Roth IRA withdrawal rules and penalties, you may have a better understanding of the benefits of a Roth IRA. If you are currently only contributing to a traditional account such as a 401(k), IRA, or 403(b), you may want to consider opening a Roth account.
Utilizing both retirement savings options, can set you up for a more prosperous retirement. For our in-depth guide on establishing a Roth account, click here.
Bottom Line
Contributing to a Roth IRA account can help you minimize your tax burden during your golden years. Opening a Roth account will help offset some of your taxes in retirement.
When you reach retirement, it’s important to understand how all Roth IRA withdrawal rules and penalties will effect you. In order to maximize your retirement savings, you should develop a withdrawal strategy. However, developing a withdrawal strategy can be a complex matter that requires expert attention. Partnering with a financial advisor can help you establish you own distribution strategy and avoid costly penalties.
