Roth IRA Withdrawals: The Exceptions Can Be as Important as the Rules

Dear Carrie,

I'm thinking of taking a distribution from my Roth IRA. What do I need to know? Are there any taxes or penalties?

--A Reader

Dear Reader,

This is a great question because a transaction that presumably would be very simple can quickly get bogged down in rules and exceptions.

The reason? While Roth IRA distributions are often tax and penalty free, there are also situations in which this might not be the case. In reality, it all depends on how long you've had your Roth IRA, your age, and what you plan to do with the money.

As always when it comes to tax issues, I suggest you talk to your accountant or tax advisor. But I can at least give you a rundown on the basics so you'll be armed with some information.

The basic rules

Because Roth IRA contributions are made with after-tax dollars, you can withdraw the contributions tax and penalty free at any time. That's the simple part. But the beauty of a Roth is that the earnings can also be tax and penalty free. And that's where things can get more complicated.

The IRS makes a distinction between what they call
qualified
and
nonqualified
distributions. According to the 5-year rule, for a distribution to be qualified, or not taxable or subject to penalty, you have to have held your Roth IRA for a period of five tax years, and meet one of the following conditions:
  • You must be at least 59½, or
  • You use the money to pay for a first-time home (10,000 lifetime cap), or
  • You become disabled, or
  • The distribution is made to a beneficiary or to your estate after you die.
Here are a couple of sample scenarios:
  • Qualified distribution--Let's say you opened a Roth IRA in 2005 and have made yearly contributions amounting to50,000. With your earnings, your account is now worth54,000. Let's also say you turned 59½ in 2016. Because you meet both the 5-year holding period and the age qualifications, you won't owe any taxes or penalties.
  • Nonqualified distribution--Now let's say you're only 45 (and you're not disabled or buying a first house). In this case, you'll be taxed on the4,000 in earnings at your ordinary income tax rate. But that's not all. Because you're under 59½, and you don't meet the other conditions, you might also have to pay a 10 percent early withdrawal penalty on your earnings. I say might because, as with all rules, there are exceptions.
  • The exceptions

    In general, if you withdraw money from your Roth IRA before you've met the 5-year holding period and/or before you reach 59½, not only is the earnings portion of the distribution taxable, but you could be subject to a 10 percent penalty on those earnings unless the distribution is used for one of the following exceptions:

    • Qualified higher education expenses for yourself and/or eligible family members,
    • Unreimbursed medical expenses that exceed 7½ percent of your adjusted gross income, or
    • Health insurance premiums if you're unemployed.
    You can also avoid the 10 percent penalty if the distribution is:
    • Made in substantially equal periodic payments over the period of your life expectancy, or
    • Due to an IRS levy of the qualified plan.

    One factor in your favor is that the IRS also has rules about the order in which funds are taken out. Withdrawals are considered to first come from contributions (which are not subject to any holding period), then from Roth conversions, and lastly from earnings. So how much you're withdrawing and what percentage comes from earnings will also determine the extent of any taxes and penalties.

    Different rules for Roth IRA conversions

    If you've converted your traditional IRA into a Roth, there's yet another set of distribution rules. Unlike contributions to a Roth that come from your income, if you're under 59½ contributions from a conversion must be held in your account for five tax years from the time of the conversion to be penalty free upon withdrawal.

    Talk to your tax advisor

    As you can see, unless you clearly fit the specific conditions for a qualified distribution, there are plenty of things to consider. Once again, as with all tax issues, talk to your advisor. It's the best way to avoid losing money--and sleep!

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    Looking for answers to your retirement questions? Check out Carrie's new book, "The Charles Schwab Guide to Finances After Fifty: Answers to Your Most Important Money Questions."

    This article originally appeared on Schwab.com. You can e-mail Carrie at askcarrie@schwab.com, or click here for additional Ask Carrie columns. This column is no substitute for an individualized recommendation, tax, legal or personalized investment advice. Asset allocation and diversification cannot ensure a profit or eliminate the risk of investment losses. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager. Diversification cannot ensure a profit or eliminate the risk of investment losses.

    The information on this website is for educational purposes only. It is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager.

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