Roth IRA’s are all the rage now-days – and 2019 is showing no sign of slowing down. With that in mind, it’s important to know the key points of having a Roth IRA. In particular, how a Roth IRA withdrawal works and what exactly the rules are.
I mean, the whole purpose of having these retirement accounts is to cash out eventually, right?
Roth IRA Withdrawal Rules – Quick and Easy
For starters, here’s the quick and easy break down for withdrawing from a Roth IRA – penalty free:
- After 59 ½ years old – You’re totally free to pull money from your account – tax free and with no penalty – if your account has been upon longer than 5 years.
- Under 59 ½ – You can pull out contributions you’ve made without paying taxes or a penalty, but not earnings made.
- Under 59 ½ – You’ll have to meet strict exemption rules to withdraw your earnings without penalty.
That’s the skinny on Roth IRA withdrawal rules, but when is money ever so simple, eh?
Things get complicated when you want to start pulling from the money earned by your account. Cashing out on that money too early can rack up some steep penalties. That is, if you don’t meet certain requirements.
As with any retirement account, the older you (and your account) are, the easier it gets. Let’s take a closer look at the Roth IRA withdrawal rules – from easiest to hardest.
Is all this nonsense confusing? Start from the beginning and learn what exactly a retirement account is and why you need one!
You’re older than 59 ½
For those of you who are at retirement age, there’s really only 2 considerations you need to make for your Roth IRA withdrawal.
- For accounts younger than 5 years old – You’ll owe income tax on the money your account earned. You won’t pay any penalty fees.
- For accounts older than 5 years – You don’t owe any taxes or penalty fees on your withdrawals.
That’s it!
Of course, if you want to withdraw funds and you’re under 59, things get much more complicated.
You’re younger than 59 ½
For those younger than age 59, you’ll be hit with a hefty 10% penalty fee on any money withdrawn from your account. Not only that, you’ll owe income tax on any money earned by your account.
That right there should tell you it’s a bad idea to pull from your IRA before retirement! That being said, there’s a few situations available that can get you off the hook for paying any fees.
Roth IRA accounts less than 5 years old
You can avoid paying the 10% penalty, but still have to pay income taxes, if you fall under these exemptions.
- Up to $10,000 for buying your first home
- Education expenses (books, tuition, and more)
- Medical expenses greater than 10% of your income
- Health Insurance premiums during unemployment
- An IRS levy made against your account
Roth IRA accounts more than 5 years old
You won’t have to pay the 10% penalty or income taxes if you meet these exemptions:
- Up to $10,000 for buying your first home
- You pass away and someone else is claiming your withdrawals
In the event that you pass away, the person who receives your retirement earnings will be exempt from having to paying any penalty or taxes. Those with a permanent disability are considered exempt, regardless of qualifications.
As you can see, the route to avoid paying any sort of penalty or taxes is rather difficult, to say the least. What’s that tell you? That you shouldn’t be pulling from your retirement account before retiring!
The difference between contributions and interest
There’s an important distinction that needs to be made here before we go any further. That is to say, what makes contributions and interest different?
If you don’t already know, with Roth IRA accounts, any money you add has already been hit with income taxes. Unlike a traditional IRA or 401(k) where you pay taxes later down the road.
One of the key advantages to Roth IRA’s is that your funds aren’t locked away from you.
Sort of.
Any contributions you’ve made are completely open for you to take as you please. That’s because Roth accounts are taxed before the money goes in.
However, that doesn’t mean you can pull the money your account has earned over time. Why’s that? For starters, the interest that has built up still needs to be taxed. On top of that, you’ll be paying a hefty penalty if you don’t follow the rules for withdrawals.‘
Learn more about how compound interest is the most powerful tool in investing!
Roth IRA Withdrawal – The 5 Year Rule
“More rules? I thought we just covered all the rules!” Ho ho, not so lucky my friend. There’s a few tidbits of information we need to cover before you can graduate from this Roth IRA withdrawal rules class.
Why is there a 5 year rule
As we mentioned before, you need to hit 2 key factors before withdrawing scott-free. Those are:
- Be 59 ½ or older
- Have an account open for 5 years or more
The purpose for this timer is to help determine if you need to any penalties when withdrawing from your account.
I know, it shouldn’t be that complicated – it’s just 5 years! But there’s a little more to it than that, particularly when we start looking at conversions (don’t worry, we’ll cover that further down).
As for when it begins, it will start on the first day of the year that you add money (contribute) to your account – regardless of when you make the contribution. Confused? Here’s an example.
If you contribute to your Roth IRA on June 12th, 2019, your 5 year “countdown” will begin January 1st, 2019.
Don’t worry. You don’t have to have a timer running on every account you have open. Roth IRAs work like an umbrella, once the oldest account is over 5 years, they’re all considered “complete”.
Roth IRA Early Withdrawal – Conversions
Alright, we need to know what a conversion is before we even consider worrying about them.
A “conversion” is simply a fancy term for transferring money from a traditional IRA, to a Roth IRA. Conversions have their own set of rules to follow, and a few quirks to consider before transferring your investments.
The Rules
First, you always have to pay income taxes when converting to a Roth IRA. While this may seem obvious, be aware that you pay based on what your current income taxes are. If you’re in a high tax bracket right now, you may want to reconsider shuffling your investment around!
Q: Why are conversions always taxed?
A: Traditional IRA’s are considered tax deferred (you pay them later). Roth IRA’s are the opposite. You pay taxes immediately, but not when you withdraw later. Thus, you still owe taxes when converting!
Second, every conversion you make has its own separate 5 year rule. Same as before, this 5 year rule is to determine whether or not you pay a 10% penalty when withdrawing.
Here’s how the tier system works when taking a withdrawal.
- Contributions you’ve made are withdrawn first
- Conversions from other accounts are taken out second
- Earnings gained from interest are the last to follow
Why rules matter
What’s so important about the process? Because every conversion has its own 5 year clock.
What this means is that even if you know your Roth IRA is over 5 years old – if you’ve made any conversions recently, you need to make sure those are also over 5 years old. If not, you’ll pay a nasty 10% penalty on withdrawal.
That being said, investment firms have made things a little bit easier on us. In that, the oldest conversion will be taken first. So if you made a conversion over 5 years ago, you should be alright.
Did you know? You can “re characterize” a contribution you’ve made from one account to another, instead of converting. Essentially this let’s you pretend you never made a contribution in the first place. This can be a helpful way to avoid paying taxes that you’d normally have to when making a conversion. Read more about re characterization over here.
TL;DR
Now you know how the exciting process of how a Roth IRA withdrawal works, Woo!
OK, it’s not that exciting. But it is an important area to understand, especially considering that – for most people – your IRA is the largest investment you’ll have in life.
While some of it may seem confusing, for the most part you’ll only need to remember the 3 pillars of Roth IRA withdrawal rules.
- After 59 ½ years old – You’re totally free to pull money from your account – tax free and with no penalty – if your account has been upon longer than 5 years.
- Under 59 ½ – You can pull out contributions you’ve made without paying taxes or a penalty, but not earnings made.
- Under 59 ½ – You’ll have to meet strict exemption rules to withdraw your earnings without penalty.
Heck, let’s make it even easier:
- If you’re under 59 ½, don’t touch your retirement fund.
That’s better!
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