Tax-Free Roth IRA Withdrawal Options – What every Roth IRA account holder should know
While Roth IRAs are funded in after-tax dollars, making a mistake on fund withdrawal could still subject you to tax and penalties on withdrawal of earnings. Here are some tips.
You must take care to plan your retirement plan withdrawals to avoid a potential 10% early withdrawal penalty. Unfortunately, each retirement account type has different rules. Here are some tips for Roth IRAs.
Roth IRA basics
Roth IRA accounts differ from other IRAs in that your contributions are made in after-tax dollars. If you follow the Roth IRA rules, your withdrawals of any earnings in the account can be tax-free. Generally, to take advantage of the tax-free distribution from a Roth IRA:
- You must be age 59 ½ or older.
- You must have had funds in the Roth IRA account for more than 5 years.
- You must understand what is being distributed (contributions, converted funds or account earnings).
- You must know your possible tax-free distribution options.
If you do not comply with these rules you could be subject to income tax and a 10% early withdrawal (distribution) penalty. But wait! There are ways to avoid income tax and the early withdrawal penalty.
Roth IRA distribution tips
- Remember contributions have been taxed. What many forget is that your initial contributions have already been taxed. The portion of your early distribution from a Roth IRA account subject to income tax is only the untaxed earnings on your contributions.
- 10% early withdrawals. Early withdrawal penalties are subject to the five year account rule and how you use the funds when distributed. It also might depend on what funds you remove from your account. Prior to withdrawing funds, ask for help to ensure you know whether you will be subject to the early withdrawal penalty.
- Qualified early withdrawals. If you use the distributions for a qualified reason, you can avoid the early distribution penalties. Some of the more common qualified early withdrawals with Roth IRA’s are:
- College. If you withdraw Roth IRA earnings to pay for college expenses, you will pay tax on the earnings withdrawn, but you will not be subject to the 10% early withdrawal penalty.
- First-time home buyer. Even if you’ve had your Roth IRA for less than five years, you can withdraw up to $10,000 in Roth IRA earnings income tax-free and penalty tax-free if it is used to buy a first home.
- Account holder disability or death.
- Unreimbursed medical expenses that exceed your itemized deduction threshold.
- Substantially equal periodic payments. These must be made over the defined life-expectancy of the IRA holder using specific rules to avoid the early withdrawal penalty.
- No minimum withdrawal requirements. Unlike other IRAs, the Roth IRA does not require you to take money out when you reach a certain age. With Traditional IRAs this withdrawal requirement occurs when you reach age 70 ½. This means you can have a strategy to never withdraw the funds in your Roth IRA as an estate-planning device. While the funds would be considered part of your estate, your heirs could withdraw the funds tax and penalty-free during their lifetime.
- Keep separate accounts. The taxability of a withdrawal can be complicated. Are you withdrawing contributions, converted funds, or earnings? How long have the funds been in the Roth IRA? Because this can be complex, try to keep your Roth IRA accounts simple. If you convert funds from another retirement account into a Roth IRA, do so in a separate account. It will then be easier to understand the impact of a withdrawal from the account.
If you have questions regarding your situation, speak to a qualified planner prior to taking any withdrawals from a Roth IRA or other tax advantaged retirement plan. It could save you plenty in potential tax and penalties.
Want to reduce your taxable income using a tax deferred contribution to an IRA but don’t have the funds to do so? If you expect a tax refund, here is a technique that may help.
Here is a tax planning tip for those who file their tax returns early and wish to contribute to a tax deductible IRA, but do not have the funds to do so.
Say you want to pay into an IRA to get a tax break but you don’t have the money? Take heart, there are ways to get around this. The IRS allows you to take the deduction now and pay later when you get your refund.
How it works
Step 1: Prepare your tax return early in the year (early February). Run the tax return considering an income reducing contribution to a tax deferred IRA. If you do not have the funds to put into the IRA, but your tax return has a refund that can fund your contribution, you are ready for step 2.
Step 2: File your tax return with the IRA contribution noted. File the tax return as early as possible to ensure your refund gets back to you prior to April 15th. E-file the return if at all possible.
Step 3: Fund your IRA prior to April 15th. Tell your IRA investment firm you wish your IRA contribution to be for the prior year.
That’s it. You have now effectively had the income reduction benefit of your IRA contribution help fund the account through your tax refund.
Timing is everything. If you use this technique it is critical that the IRA is funded on or before April 15th. If it is not, your tax return will need to be amended.
Refund not received in time. If you do not receive your refund in time, you may not have the funds to make a timely IRA deposit. In this case, you may need to borrow funds on a short-term basis until the refund is received.
No extensions. The IRA contribution for the prior year must be made by April 15th of the following year (the original filing due date). This is true even if you file your return under an approved extension period.
While not for everyone, this tax tip could help you fund more of your retirement on a tax deferred basis.