Roth Withdrawals – I’m ready to get that tax free money….
KEY TAKEAWAYS
Roth Contributions can ALWAYS be distributed without taxes or penalties.
Don’t withdraw from your Roth IRA until you are over Age 59 ½ - unless you qualify for an exception.
Roth IRA’s do not have Required Minimum Distributions.
There is a 60-day tax free/penalty free option to withdraw, however be cautious on how you use this.
You took great advice from a friend years ago to open and start contributing to a Roth IRA. Over time you have employed other strategies like Roth Conversions and Backdoor Roth IRAs to boost your Roth IRA balances. Now it’s time to start drawing from those dollars. In a previous blog post, Roth IRA Owners Beware of the 5-Year Rule we touched on the 5-year Rule that must be adhered to in order to ensure that your distributions from your earnings are TAX FREE when you take them. Because after all, isn’t that the greatest benefit of owning a Roth IRA?
What other things must you consider before taking distributions from your Roth IRA?
First, you can distribute ALL CONTRIBUTIONS you’ve made to the Roth IRA TAX FREE. Those will be the first dollars that come out of the account. You’ve already paid taxes on these dollars when you earned them. The IRS is not going to penalize you a 2nd time by taxing your contributions on the way out. And there is no 59 ½ rule here. You can take out contributions ANYTIME even if you are under age 59 ½.
AVOID the 10%, Pre-59 ½ Penalty Rule. Don’t distribute any investment earnings in your Roth IRA before A59 ½, otherwise you will pay a 10% penalty on that amount. HOWEVER, the IRS does give some exceptions that will allow you to avoid the penalty before 59 ½.
EXCEPTIONS:
First-time home purchase – You are allowed up to $10,000 to help pay for a first-time home purchase. If you are married, both of you can take this amount to help buy that first home.
You become disabled or pass away.
Qualified Education Expenses (Must adhere to 5-year rule - it’s been more than 5 years since you first contributed or converted) – things like tuition, fees, books, supplies and if enrolled at least half time, room and board qualifies as well. This can be used for you, your spouse, child, or grandchild.
Qualified Expenses for Birth or Adoption (5-year rule applies) - Limited to $5,000 per birth or adoption. This is a relatively new exception that came about via the SECURE ACT that was signed into law in December 2019.
Unreimbursed medical expenses or health insurance if unemployed (5-year rule applies).
Required Minimum Distributions (RMDs)
There are NO Required Minimum Distributions for Roth IRAs. Unlike Traditional/SEP/SIMPLE IRA’s and 401k’s that require you to take RMDs the year you turn age 72, Roth IRA’s do not have that requirement. Why might that be? Well, one reason could be because the IRS doesn’t have any skin in that game. When you take out your Roth dollars, those dollars have already been taxed, so it’s not as if the government is missing that revenue if you never take those earnings out of your Roth IRA. No matter the reason, it is a great benefit to be able to keep those tax-free earnings growing for you in the stock market.
What if it’s an Inherited Roth IRA?
In this case, just like an Inherited Traditional IRA, you must take your Required Minimum Distributions. However, if those assets had been in the original owner’s account for 5 years or more, these RMD’s are still TAX FREE.
Some other Considerations….
IRA 60-Day Rule
Let’s say you have an emergency that needs immediate funding. You recently purchase a home and that has temporarily depleted your “rainy day” funds in your bank account. Is the Roth IRA an option if you don’t meet the 59 ½ rule or the 5-year rules?
YES – the IRS allows you to “borrow” from your Roth IRA without paying taxes or penalties IF YOU REPAY THE AMOUNT WITHIN 60 DAYS. This is essentially a short-term, interest free loan, but do not miss the 60-day deadline. If you do, you could face taxes and penalties.
One other caution – this can only be done once every 12 months. So, if you took a 60-day distribution on October 1st and repaid the Roth IRA on December 1st, you would not have this option available to you again until October 1st the NEXT YEAR.
SHOULD YOU withdraw from your Roth IRA?
What if you have other options to access dollars? Maybe you’ve built up a nice nest egg that also includes a Traditional IRA portfolio that received a large 401k rollover from previous employer. We know that a Roth IRA has amazing tax benefits that can grow and compound over time. You might consider NOT taking advantage of those tax-free dollars just yet. Why?
You might be in a particularly low tax year. Let’s say you had a tremendous amount of tax deductions this year and now you are suddenly in the 12% tax bracket instead of 22%. You need to take a withdrawal from your investments to cover significant home repairs before year end. You know that this year is an anomaly, and you won’t have those same deductions next year and you will likely be in the 22% bracket.
In this instance, it might make sense to take a distribution from your Traditional IRA or 401(k) knowing that you will have to pay taxes on those dollars, but at the LOWER TAX RATE of 12%. This will allow you to leave your Roth IRA account untouched and continuing to grow in the markets where all that investment growth is then TAX FREE. Better yet those future withdrawals can be used when you are in higher tax years.
The bottom line is Roth IRAs are a fantastic savings tool as they provide an opportunity to take out dollars TAX FREE, but it is also important you are clear about the specific rules on how to distribute those dollars without incurring penalties or having to pay taxes.
IMPORTANT DISCLOSURE INFORMATION
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