All About IRAs
The Roth IRA: Early Withdrawals
The IRS does not care from which Roth IRA you
take a withdrawal. If you have multiple IRAs, they are considered as one Roth
IRA for withdrawal purposes. Further, the IRS has deemed that Roth IRA
distributions MUST be withdrawn in a specific order, and that order applies
regardless of which Roth IRA is used to take that distribution. Roth
distributions should be made in the following order:
- From non-taxable annual contributions to a
Roth IRA (other than conversion amounts)
- From conversion contributions, on a
first-in, first-out (FIFO) basis
- From earnings
Who cares? You might -- especially if you find
that you have to take an early withdrawal. Let's look at some examples.
Penalties on Earnings from Contributions
Unless an exception applies, most distributions
from a Roth IRA before the owner reaches age 59 1/2 will be subject to an "early
withdrawal penalty" of 10% on the amount of the distribution. Be very careful
NOT to confuse the early withdrawal penalty with the taxes imposed on a
non-qualified distribution. A non-qualified distribution imposes an ordinary
income tax on the distribution, but the early withdrawal penalty will be imposed
in addition to that tax.
Example #1
Jim, age 30, made a Roth IRA contribution of
$2,000 in 1998. In 2005, Jim's Roth IRA has a balance of $3,500. Jim decides to
close his Roth IRA in a non-qualified distribution that year. Since the
distribution is non-qualified, Jim will owe taxes on his Roth earnings of
$1,500, and will pay tax on this amount at his marginal tax rate. In addition,
since the distribution took place before Jim reached age 59 1/2, and since Jim
did not meet any of the exceptions, Jim will also be assessed a 10% early
withdrawal penalty on the earnings. If we assume that Jim is in the 28% marginal
tax bracket, he will pay $420 in tax on the earnings, and will pay a penalty in
the amount of $150 on the early distribution. This is a very steep price to pay.
Exceptions
The early withdrawal penalty does not apply to
distributions that:
- Occur because of the IRA owner's
disability. (This can be a very narrow definition, so if you get a severe
paper cut, don't consider a Roth IRA distribution for a disability until you
review IRS Code Section 72(m)(7) and
IRS Publication 590.)
- Occur because of the IRA owner's death.
- Are a series of "substantially equal
periodic payments" made over the life expectancy of the IRA owner.
- Are used to pay for unreimbursed medical
expenses that exceed 7 1/2% of adjusted gross income (AGI).
- Are used to pay medical insurance premiums
after the IRA owner has received unemployment compensation for more than 12
weeks.
- Are used to pay the costs of a first-time
home purchase (subject to a lifetime limit of $10,000).
- Are used to pay for the qualified expenses
of higher education for the IRA owner and/or eligible family members.
- Are used to pay back taxes because of an
Internal Revenue Service levy placed against the IRA.
Penalties on Conversions From a Traditional
IRA to a Roth IRA
The penalty rules regarding conversions are a
bit different than those for annual contributions, which may be taken at any
time for any purpose free of income taxes and penalty. An early withdrawal of a
conversion contribution has a different twist. The early withdrawal penalty
applies to a distribution of conversion money from a Roth IRA when:
- The distribution is made within the
five-tax-year period starting with the year that the conversion was
distributed from a regular IRA; and
- Only to the extent that the distribution is
attributable to amounts that were includable in gross income as a result of
the conversion.
Example #2
Paul made a $20,000 conversion from his regular
IRA to a Roth IRA in 1998. The entire amount converted was includable in Paul's
income for 1998. Paul made no additional contributions or conversions to a Roth
IRA in 1998 or in later years. In 2001, before he is age 59 1/2, Paul withdraws
$10,000 from the Roth IRA. Paul will have no tax to pay on this withdrawal
because he paid income taxes on the full $20,000 he converted in 1998; however,
he WILL have to pay a 10% penalty (or $1,000) unless one of the IRA early
withdrawal exceptions apply. Why? Because Paul didn't keep the conversion amount
in his Roth IRA for the required five-tax-year period since his original
conversion.
So, if you are going to take funds "early" from
your Roth IRA, weigh your conversion decision very carefully -- especially if
you made non-deductible contributions to your original IRA. If you did
make non-deductible contributions to your regular IRA, you'll generally be worse
off by converting to a Roth IRA and taking the funds early than you would be by
simply taking the funds from the regular IRA.
Why? Because a pro rata part of all withdrawals
from a regular IRA are treated as coming out of non-deductible contributions.
But, amounts withdrawn from Roth IRA conversions are treated as coming out of
income taken into account on the conversion first.
Not quite clear on how this works? Let's take a
look at an example:
Example #3
Karin has a traditional IRA with a balance of
$12,000 -- $6,000 of that IRA balance was from prior-year deductible
contributions and total IRA earnings. The other $6,000 represents prior-year
non-deductible contributions. Karin is contemplating a Roth IRA conversion, but
also wants to take a distribution of $4,000. Karin's options are as follows:
- She can leave her money in the traditional
IRA and take the $4,000 distribution. She'll be taxed on half of the
distribution ($2,000) because half of the account is deductible contributions
and earnings. She'll also pay a 10% penalty, but only on the $2,000 taxable
distribution. The other $2,000 is tax- and penalty-free since it came from
prior non-deductible contributions to the IRA.
- She can convert the entire traditional IRA
to a Roth IRA and then take the $4,000 distribution. This is a bad choice for
Karin. Once Karin takes the $4,000 distribution, she'll be subject to a 10%
penalty on the entire distribution, or $400, because of the ordering rules.
She won't have to pay any tax on the distribution (since the tax was paid when
she converted the traditional IRA to the Roth IRA), but making this choice
causes Karin to pay an additional $200 in penalties that could have been
avoided with proper planning.
On the other hand, if you are reasonably young
(under age 50) and expect to need to withdraw funds from your IRA in five years
(and can't use any exceptions to avoid the 10% penalty), you might be better off
converting funds from your regular IRA to a Roth IRA now. If you wait until
after the five-tax-year period to withdraw money from a Roth
IRA, the 10% penalty won't be imposed, even if you aren't yet 59 1/2 and don't
meet any other exception to the penalty.
Why? Because, for a Roth IRA, you have met the
five tax-year exception on the converted funds and therefore dodge the 10%
penalty on these distributions. But, there is no five-tax-year
exception for a traditional IRA. So, while you would still pay tax on the
earnings in either case, you would escape the 10% penalty by converting to a
Roth IRA.
Still not clear on this? Another example might
be in order.
Example #4
Rick converted $15,000 from his traditional IRA
to a Roth IRA in 1999, and another $20,000 from a second traditional IRA in
2003. These conversions were all taxable to Rick when they occurred because he
had made no non-deductible contributions to his traditional IRAs. He has no
other Roth IRAs and he has not made any additional contributions to this Roth
IRA since the original conversions.
In 2006, when Rick is still under age 59 1/2,
he takes a distribution of $15,000. Is this distribution subject to tax? Nope,
since the taxes were paid on these funds at the time of the conversion from the
traditional IRA to the Roth IRA. Is this distribution subject to the 10%
penalty? Nope again, because Rick held the conversion funds in the Roth IRA
account for longer than the required five-tax-year period.
But what if Rick took a distribution of $20,000
in 2007? In that case, he would still receive $15,000 of that distribution tax-
and penalty-free because it has been more than five tax-years since his first
conversion of $15,000. But the second IRA was converted less than five tax-years
ago. Therefore, the remaining $5,000 of his $20,000 distribution will be
penalized 10% for an early withdrawal because he has not yet met the
five-tax-year rule to tap into the second conversion contribution of $20,000.
And when he takes that sum, he will have only $15,000 of conversion money left
before he begins to take earnings from that Roth IRA.
As you can see, the tax-planning implications
on Roth IRA withdrawals are numerous -- too numerous to mention here. Different
tax and penalty rules can apply to distributions coming from contributions,
conversions, or earnings.
Not only that, the rules regarding the 10%
penalty on "early" (less than five tax-years) distributions relative to
conversion amounts are determined for each conversion, and might not necessarily
be the same five-tax-year period that you use to determine if a distribution is
"qualified" for income tax purposes.
And, the penalty rules are different for
conversions than they are for earnings from contributions. It can be a real
mess.
If your Roth IRA consists of only contributions
or only conversions, these rules aren't too difficult to follow. But if your
Roth IRA consists of contributions, conversions in different years, and earnings
on both, then the "qualified" distribution rules and the penalty rules can get
very complex.
So, you really need to know the tax impact of
your decision prior to removing any of your Roth IRA funds -- you can't just
guess. Guessing could be hazardous to your wealth.
Your best bet? Keep your paws off your Roth IRA
account unless your distribution is qualified and you meet one
of the penalty exceptions. It'll make your tax life much easier.
Table of Contents:
-
What Are Retirement Accounts?
-
Employer Based
Retirement Plans
-
401(k) Plans
-
Individual Retirement Accounts (IRAs)
-
Roth IRA
-
What is a Rollover IRA?
-
Converting and
Recharacterizing of an IRA
-
Education IRA & SEP IRA
-
Self Employed Retirement plan: Keogh
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