The best strategy for building retirement savings is to start early, contribute regularly, invest wisely, and let time in the market be your ally. However, life events may force even committed savers to make an early withdrawal from their Roth IRA.
How a Roth IRA is Designed to Work
Unlike a traditional IRA or a work-related 401(k) account, a Roth IRA is funded with after-tax dollars. The tax benefit of a Roth IRA is that investment earnings grow tax-free, and qualified withdrawals (withdrawals that meet this treatment) during retirement are tax-free and penalty-free.
Withdrawing Your Contributions from a Roth IRA
Funds deposited into a Roth IRA have already been taxed. Therefore, a Roth IRA holder can withdraw any amount of contributions from the account without incurring a penalty. However, earnings from a Roth IRA – the money earned from investing in stocks or other assets – may be subject to a 10% penalty and taxes.
Qualified Distributions vs. Non-Qualified Distributions
A qualified distribution from a Roth IRA refers to any withdrawal of earnings after the first five years of the account (this five-year period begins with the tax year of the first contribution to the account) and meeting the self-service requirements of the Internal Revenue Service for tax purposes.
Exceptions to the Early Withdrawal Penalty
Some additional exceptions allow Roth account holders under age 59½ to avoid the early withdrawal penalty. Roth account holders who meet the five-year rule can avoid the penalty if the money is used for specific purposes, including:
- Qualified higher education expenses up to a certain limit.
- Qualified expenses not exceeding $5,000 for birth or adoption.
- Unreimbursed medical expenses or health insurance if you are unemployed.
- Unreimbursed medical expenses that exceed a certain percentage of adjusted gross income.
- Expenses you incurred during a tax year affected by a qualified natural disaster.
Penalties on Non-Qualified Distributions
Early withdrawals from a Roth IRA are subject to a 10% penalty in addition to including those earnings as income when filing a tax return for that year.
For example, if someone makes a non-qualified withdrawal of $5,000 from a Roth IRA earnings, they must report $5,000 as part of their total income on their tax return for that year. The individual will also incur a penalty of $500.
Other restrictions on a Roth IRA may lead to additional penalties. You will receive a 1099-R form for any distributions you received. If codes 1 (early distribution, no known exceptions), 5 (prohibited transaction), or 8 (excess contributions plus excess earnings) appear, you may be liable for taxes or penalties.
Conclusion
Roth IRAs are a powerful tool for saving and investing for retirement. Money invested in a Roth IRA grows tax-free, and qualified distributions are also tax-free. Because the IRS wants to discourage people from using Roth IRA savings early, they have imposed significant penalties on early distributions.
The rules for qualifying and non-qualifying early distributions from a Roth IRA can be complex. If you are confused, it’s always best to consult a qualified tax advisor before withdrawing earnings from a Roth account.
FAQs
When do you pay the penalty for early withdrawal from a Roth IRA?
A 10% penalty applies to non-qualified distributions from a Roth IRA and is typically withheld from any distributions. Federal and state taxes may also be withheld at the time of distribution. If you choose not to withhold Roth IRA tax at the time of the distribution, you may need to make estimated tax payments on the distribution.
Does…
Can you borrow from a Roth IRA account?
You cannot borrow from any IRA account, including Roth IRA accounts.
Can I withdraw from a Roth IRA to buy a house?
You can withdraw up to $10,000 from a Roth IRA without penalty or tax to buy a first home for certain qualifying individuals. Of course, you can withdraw any amount of your original contributions for any reason from a Roth without facing any penalties.
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Sources:
- IRS. “Topic No. 557 Additional Tax on Early Distributions From Traditional and Roth IRAs.”
- IRS. “Retirement Plan and IRA Required Minimum Distributions FAQs.”
- IRS. “Publication 590-B Distributions From Individual Retirement Arrangements (IRAs).”
- IRS. “Retirement Plans FAQs Regarding Loans.”
Source: https://www.thebalancemoney.com/what-is-the-early-withdrawal-penalty-for-roth-ira-5270459
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