A Detailed Guide to Roth IRA Withdrawals

People invest in retirement plans so they can live comfortably off the money that has grown over the years. It gives them a sense of relief and comfort knowing they have something they can rely on when they grow old and cannot work to earn any more. Most retirement accounts are structured such that you make contributions during your earning years, but the money cannot be withdrawn until retirement at 60. This gives the money enough time to compound and grow into a corpus. But, what if you happen to require funds before you retire?

Roth IRAs are a great way of growing your money in a tax-free manner, but early Roth IRA withdrawal can lead to penalties and taxes. However, there may be some exceptions where you can withdraw your money from your Roth IRA account prematurely. For more questions on Roth IRAs and how they could fit in your future retirement plans, consult a financial advisor for more information.

Read on to know more about Roth IRAs and the withdrawal rules involved.

Understanding Roth IRAs

A Roth IRA is a unique type of retirement account that allows the investor’s money to grow tax-free and attracts no taxes upon withdrawal either, provided certain criteria are met. After 59.5 years of age, the investor can withdraw the money from their Roth IRA completely tax-free and penalty-free if the account has been open for more than five years. A Roth invests your money in a portfolio of stocks, bonds, mutual funds, or other investments as per your choice to grow your principal investments into a large corpus over time. While a Roth IRA is similar in its functioning to few other qualified retirement plan accounts, this account offers some special benefits and is generally less restrictive than other accounts.

Investors can contribute their after-tax savings to a Roth IRA account and save for their retirement years in one of the most tax-efficient manners with a Roth IRA. Contributions can be made at any age, as long as the account holder has earned income. There are, however, certain limits to contributions enforced by the IRS. Presently, an individual cannot contribute more than $6,000 in a year to all IRAs (traditional & Roth) combined. For those over the age of 50, an additional $1000 is allowed per year, taking the maximum contribution to $7,000 as permitted by the IRS.

A Roth IRA may be a great investment avenue for young investors who have a lower annual income and want to earn more in the long run. The money contributed by investors in a Roth IRA is invested in a range of different asset classes, from stocks, bonds, gold, ETFs, mutual funds, and other investment vehicles.

The Roth IRA advantage

What makes the Roth IRA a preferred retirement plan is the fact that investors don’t have to pay taxes on the money they withdraw from the account after a certain period. There is no penalty and no taxes on withdrawals if they are made in adherence to the norms. Let's understand why this is a big deal.

As far as contributions are concerned, almost anyone can contribute to a Roth IRA, given their modified adjusted gross income does not exceed the threshold underlined by the IRS. The limit for 2021 is $140,000 for single filers and $208,000 for joint filers.

Taxes have seen an upward growth over time, and the trajectory is still pointing up. The top tax rate of 37% is being considered for a further hike by congress, and should the bill pass, it can add to quite some pains for the investors. It is financially more beneficial to pay taxes now, at 37%, than pay taxes in the future at a higher rate.

Youngsters who have just started earning recently and are considering investing for the future may explore adding a Roth IRA account to their portfolio. An obvious advantage is afforded by the long investment horizon, which grows their money into a large corpus. Additionally, with a low income and a lower income tax rate, young investors can afford to max out their IRA contributions, since their after-tax income is unlikely to be impacted much by tax policy changes.

With that said, even if you do not want to withdraw the funds in your Roth IRA in old age, you can allow the funds to continue growing over the years since, unlike other IRA schemes, there is no mandatory withdrawal feature with a Roth IRA

Another advantage of IRA accounts is that the tax-efficient growth of the funds can continue even after the death of the investor, with the account being passed down to the heirs, who can continue reaping the benefits of a tax-free investment plan. Basically, the income your heirs get from your Roth IRA will also be tax-free - this is also why Roth IRAs often figure in legacy planning.

Roth IRA withdrawal rules

Compared to other IRA schemes, the rules for withdrawing funds from a Roth IRA account are fairly simple.

Below are the norms Roth IRA investors must know before withdrawing money from a Roth IRA:

1. Withdrawals are tax-free when taken after the investor attains 59.5 years.
2. No penalty is levied if you take money out of a Roth IRA after 59.5 years of age when the account has been open for more than five years. If the account is held for less than five years old, the withdrawal amount will be liable for taxation.
3. A penalty may be charged if you transfer your Roth IRA account and do not deposit the cheque into the other account within 60 days of the cheque being issued to you.
4. The contribution amount made to Roth IRA can be withdrawn anytime by the investor without any penalty being charged since the contribution amount is after-tax savings. However, if the investor withdraws the investment earnings from the Roth IRA before 59.5 years of age or before the account is older than five years, a penalty of 10% plus taxes is levied on the withdrawal amount.
5. Investors can also withdraw the investment earning (interest) in special circumstances as an exception.

The Roth IRA 5-year rule

Withdrawing money from a Roth IRA may seem like a very simple process compared to the stringent rules of the other retirement planning investment avenues. But there are intricate Roth IRA withdrawal rules in place that you need to follow to avoid fines and penalties.

The 5-year rule for Roth IRAs are applicable in the following areas:

1. First Roth IRA contribution

As per this rule, the investor must wait for at least five years after making their first contribution to a Roth IRA if they want to withdraw the investments tax-free without any penalty. The five-year period starts from the day of the tax year for which a contribution was made. For example, if you made a contribution in 2021 to Roth IRA for the 2020 tax year, then the 5-year period will end in 2025 and not 2026. Conversely, this means that if you are over 59.5 years of age but it has not been five years since your first Roth IRA contribution, you can withdraw the funds from your Roth IRA account without any penalty, but you will have to pay taxes on the investment earnings.

2. Inherited IRAs

If you inherited a Roth IRA account from anyone except your spouse, you have the option of taking a lump-sum distribution of any amount. The only caveat is that you must withdraw all of the funds in the account within five years as mandated by the IRS. However, if the owner of the account who passed on the Roth IRA to their heir opened the account not more than five years ago, the amount being withdrawn will be liable for taxation.

Inheritors also have the option of spreading out the mandatory minimum distribution they have to take for a period of up to 10 years. Note here that Roth IRAs do not require withdrawals until after the death of the owner. There is no concept of RMDs for Roth IRAs until or as long as the investor is alive.

3. Converting other IRAs to a Roth IRA

Many people, especially those with high taxable income, rollover their traditional IRAs into Roth IRAs to make use of its tax advantage. However, investors converting to Roth IRA must ensure that they abide by the 5-year rule before withdrawing the funds from their Roth IRA.

The IRS put the rule in place to prevent taxpayers from abusing the tax-free feature of Roth IRA. Therefore, investors rolling over to a Roth IRA must wait for a full five years, starting from 1 January of the year in which they convert to Roth IRA. Investors converting in the latter half of the year will have to wait for more time to be able to withdraw their funds tax-free.

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Roth IRA withdrawal rules for those aged 59.5 or less

You will have to pay taxes and a fine if you withdraw the investment earnings from your Roth IRA if you are under 59.5 years. The investment horizon further influences the withdrawal rule from a Roth IRA.

The following are the two situations in line with the Roth IRA 5-year rule:

1. If you have held the account for less than 5 years

If you are younger than 59.5 years and your Roth IRA has not been open for at least 5 years, you may be able to take distributions but with a 10% penalty and taxes levied to the withdrawal. The IRS has laid out a few exceptions where investors can take distributions in special situations and avoid penalties (taxes will still have to be paid).

2. If you have held the account for more than 5 years

If you have held a Roth IRA account for more than five years and are under 59.5 years of age, you can withdraw the contribution amount from your account at any time without paying any taxes or penalties. However, if you wish to take distributions from the interest earned on the investment, you will be levied both a 10% penalty and appropriate taxes.

Nevertheless, you can claim periodic distributions from your account, avoiding both the penalty and taxes if you qualify for exceptions.

Exceptions to withdrawal from Roth IRA when you are younger than 59.5 years

As mentioned before, for those with accounts older than 5 years, no penalty or taxes will be charged for these acts. For those with accounts younger than 5 years, both a tax and penalty are charged; however, if the withdrawal is for a qualified exception, the penalty is waived off, and only taxes are charged.

The exceptions are as follows:

1. First-time homebuyer exception: You can take distribution worth $10,000 in your lifetime to buy a house if you or your spouse have not owned a house in the past two years. You could be purchasing or building the house for yourself, with a spouse, or even for your parents. If you are married, your spouse can add in another $10,000 from their Roth IRA distribution in a similar situation.


2. Qualified education expenses: You can take distributions to pay for tuition, fees, books, other supplies if you are pursuing higher education. For part-time students, accommodation and boarding are also covered. This can be done for yourself, your children, and your spouse. However, it is important to check with the school first to make sure that your program qualifies for the deduction.


3. To pay for medical expenses that have not been reimbursed.


4. To pay for health insurance when you are unemployed.


5. Permanent disability: If a permanent disability makes you incapable of working. You will need to furnish proof of your permanent disability for this.


6. For expenses related to childbirth or adoption.

Roth IRA withdrawal rules for those over 59.5 years of age

1. If you have held the account for less than 5 years

If you are 59.5 years or older and have held the Roth IRA for less than 5 years, the withdrawals will only be subject to taxation but no penalties.

2. If you have held the account for more than 5 years

If you have held your Roth IRA account for over 5 years and have completed 59.5 years, you can withdraw all of the money in your Roth IRA account which will be tax-free and penalty-free.

Conclusion

Don’t let contribution and early withdrawal limitations keep you from benefiting from the several advantages of a Roth IRA. Being an account that collects post-tax contribution, it enables you to retire peacefully with a large corpus that you may be able to withdraw tax-free and also penalty-free should you adhere to the rules of the IRS.

Should your income be high for opening a Roth IRA account, there is a work-around for that too. The IRA permits getting a “back door Roth IRA”. For this, you can use a traditional IRA account and contribute funds to it (which has no limit) and then move it into a Roth IRA account using Roth conversion.

When the Roth IRA withdrawal rules are obeyed, you get a multitude of benefits in your retirement. However, if you have no other option but to dip into your Roth IRA savings to meet some fund requirements, you may check your eligibility and avoid some penalties if you qualify for the special situations as discussed in this article. Having a proper withdrawal plan in place along with consultations from a financial professional can help you protect your assets.

For further assistance while planning for your retirement, use the free advisor match tool and get matched with 1-3 vetted financial fiduciaries who may be able to create a customized retirement plan for you. You may set up an interview with the financial advisors before you decide to engage with one.