Dumb Money: Early Roth IRA Withdrawals

by Kevin on September 20, 2010

Last week I told you taking an early withdrawal from your 401k was a very dumb move. The taxes and fees you pay take a hugWehe chunk out of your withdrawal leaving you anywhere from 50% to 65% of what you originally withdrew.

Astute reader Jimbo left a comment and asked:

How about pulling from a ROTH? As bad? Worse? Better? [Than pulling from your 401k.]

I’m going to assume he was asking about a Roth IRA and not a Roth 401k.

Roth IRA Minimum Withdrawal Age

To refresh your memory we’re talking about taking money out of retirement accounts before that account’s rules say you can. This isn’t something you do on a whim — you really need to consider the costs involved. But we’re talking about desperate measures for desperate times. I’m assuming you’ve tapped out your emergency fund and any extra cash sitting around for whatever emergency you’re facing (sudden job loss, car wreck, etc.).

So if you’re going to be pulling money out of your retirement accounts early you need to know at what age “early” is considered. Thankfully yours truly has written an article that covers the three major retirement accounts and when you can begin to withdraw funds tax and fee-free.

For the Roth IRA you never have to withdraw money, but you must be at least 59 and 1/2 years of age to be able to withdraw without paying taxes or fees.

Roth IRA Early Withdrawals

Your contributions to a Roth IRA (or a multitude of Roth IRAs assuming you stay under the annual contribution limit) are made with after-tax dollars. You’re guessing that your tax rate will be higher in retirement than it is today so you disregard the tax benefit of a traditional IRA or 401k contribution.

Since the original contribution was after-tax you shouldn’t pay any tax penalty for withdrawing early, right?

Unfortunately that would be logical, and thus is not the case.

Qualified Distributions

First you must know if your withdrawal is a qualified distribution or a non-qualified distribution. If your distribution is qualified then it is tax and penalty free.

To be a qualified distribution it must meet one of the following criteria:

  • be made when you are 59 and 1/2 or older
  • be made to you after you become disabled (in the government / IRS’ eyes)
  • be made to your estate or beneficiary after you die
  • be used to pay for expenses involved with buying your first home

Meet those qualifications and you’re good assuming also that it’s been at least five years that you’ve held the money in the account. (Yes, it’s complicated. Check the IRS website for all the gritty details.)

If it does not meet those qualifications then you’re looking at a non-qualified distribution.

Non-Qualified Distribution

If you’re taking a non-qualified distribution it isn’t automatically going to hit with taxes and fees.

Distributions from all your Roth IRA accounts (the IRS lumps them together for these purposes) come out in this order:

  1. contributions
  2. conversion contributions
  3. earnings (on your contributions)

If you withdraw up to your contributions then that distribution is tax and fee-free.

If you had converted a traditional IRA to a Roth IRA, but only withdraw everything but your earnings you won’t pay taxes and fees — but only if you’ve held the money in the account for at least 5 years.

If you get into your earnings that’s where your fees and taxes kick in. You’ll take 10% off the top in fees as well as paying taxes on the amount of the earnings.

Early Withdrawing from Roth IRA is Better

I’m not saying it’s a great option, but since you can avoid paying taxes on your contributions that’s a decent place to start if you absolutely had to get your hands on some cash. But be careful with the earnings — it then looks just like your 401k for the taxes and fees.

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