Roth IRA Withdrawal

So now you need the money in your Roth IRA to start footing the bill for your retirement.  Or maybe you have encountered a hardship which requires you to take a Roth IRA withdrawal.  It is important that you understand the different rules that surround a Roth IRA distribution.  Is your Roth withdrawal a qualified or non-qualified distribution?  Or, are you part of that special group of people which are taking a Roth IRA withdrawal from a Roth IRA conversion account.  With this article, we will cover the various rules which govern whether a Roth withdrawal will be hit with taxes or penalties. 

The beauty of the Roth IRA is that if you follow the rules, you can grow and withdraw all your money tax free at retirement.  Unlike the traditional IRA, you will not have to add your Roth IRA distributions to your taxable gross income come tax time. 

Let’s move into the tax consequences and rules surrounding the three different buckets we mentioned above.  Keep in mind that our sections on qualified and non-qualified distributions do not take Roth conversions into account.  We will discuss this separately.

Qualified Roth IRA Withdrawal

Qualified distributions will not pay any taxes on any of the funds that they withdraw, including capital gains.  A Roth withdrawal can be considered qualified if it meets the following requirements:

1.    Distributions must be made at least 5 years after the beginning of the tax year in which the contribution was made for.  Individuals have up to the tax filing deadline to make a contribution for the tax year.  For example, a Roth IRA contribution for 2009 tax year can be made up to April 15, 2010.  If you made your contribution on March 31 of 2010, it would qualify for a Roth IRA distribution on Jan 1, 2014 (or 5 years from the first day of the tax year)

2.    In addition to rule #1, your distribution must fall within one of the following 4 categories:  Your age exceeds 59.5, you have become disabled, distribution is made to a beneficiary in the event of your death, or you are a first time home buyer. 

Non-Qualified Roth IRA Withdrawal

A non qualified Roth IRA distribution is pretty simple to define; it is a distribution which does not meet the guidelines to be qualified, meaning you don’t satisfy BOTH rules #1 and #2.  Non-qualified distributions are subject to taxes on investment gains and also an early withdrawal penalty.  However, a non-qualified Roth IRA withdrawal does not have to be taxed.  Remember, contributions to a Roth IRA can be withdrawn at any point in time without any taxes or penalties.
For any Roth withdrawal that exceeds the total contribution to the Roth, taxes and penalties can be imposed.  For example, if you have contributed $20,000 to your Roth IRA over the past 7 years and your account balance is now $30,000, you will only be responsible for paying taxes and any applicable Roth IRA early withdrawal penalties on withdrawals exceeding $20,000. 

We mention the term “applicable” and like many other rules, there are exceptions which allow you to avoid paying the early withdrawal penalty.  The exceptions that we list here will allow you to avoid paying the 10% early withdrawal tax on gains which are withdrawn, but not the federal taxes.  These include being above the age of 59.5, being disabled, paying qualified first time home buying expenses, high amount of unreimbursed medical expenses, distributions as part of SEPP (substantially equal periodic payments), receiving funds as beneficiary of IRA, covering medical insurance costs after job loss, IRS levy, and distributions not exceeding higher education expenses.

Roth IRA Distribution within a Roth Conversion

The Roth IRA conversion uses slightly different rules.  The first difference lies in the 5 year rule that we established as Rule #1.  Rather than counting from the beginning of the tax year, the 5 year waiting period begins on a calendar year basis.  For example, a Roth conversion made on March 31, 2008 will not fulfill the 5 year rule until 5 years after Jan 1, 2008.  Therefore, if you are thinking of converting from traditional to Roth IRA, do so before the end of the year. 

Secondly, each conversion is treated separately.  For example, each conversion will have its own 5 year rule associated to it.  Therefore, you will need to keep track of the conversion dates and balances converted.  The calculation for determining taxable gains in this scenario is a bit complicated and we will cover this in our chapter about Roth IRA withdrawal ordering rules.

A Roth IRA withdrawal from a Roth conversion account is also subject to taxes on gains and the 10% early withdrawal penalty just like a regular Roth IRA would be.  The same exceptions listed above would exempt an individual from the Roth IRA early withdrawal penalty.

<< Part 1 - Roth IRA Overview
<< Part 2 - Roth IRA Contribution
<< Part 3 - Roth IRA Conversion
Part 5 - Distribution Ordering Rules >>
Part 6 - Recharacterization >>
Tim Ord
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