Any distributions of investment gains taken from your Roth IRA prior to age 59 1/2 are considered early withdrawals.
Look at the term “investment gains”. What does this mean? Investment gains are the monies earned (interest, dividends or capital gains) from your original contribution. The next question is – Why is this important?
It is because if you withdraw any money YOU contributed (original contribution) it is tax free. The reason is that you contributed to you Roth IRA with after-tax funds. No need to pay tax twice on your money!
Be careful that you don’t withdraw the “investment gains”. This is where it gets a bit tricky. If you withdraw any investment gains prior to age 59 1/2, then you'll owe income taxes and a 10% early withdrawal penalty on those funds, the “investment gains”
Here is an example:
At age 21, you open a Roth IRA and contribute $5,000. You never make any additional contributions.
Fifteen years later, you decide to close the account. It's now worth $15,000.
How much of that $15,000 do you get to keep?
By closing the account early, you don't owe any taxes or penalties on $5,000 of the $15,000.
Why is this?
Because you can withdraw your original contribution any time both tax-free and penalty-free.
But the remaining $10,000 is considered an investment gain. As a result, it's subject to income taxes and a 10% Roth IRA early withdrawal penalty.
An early withdrawal of your original contribution is always tax-free and penalty-free.
An early withdrawal of your investment gains prior to age 59 1/2 is subject to a 10% Roth IRA early withdrawal penalty as well as applicable income taxes.
The 5 Year Rule:
Even if you reach age 59 1/2, you still need to meet one more requirement before you can withdraw investment gains tax-free and penalty free.
What is this requirement?
It is the federal tax code's “5 year rule”.
This means your Roth IRA needs to be funded for at least 5 tax years before you can make tax-free and penalty-free withdrawals.
Here is an Example:
You are 59 yrs old and you decided to convert your Traditional IRA to a Roth. You do that in the year 2007, paying the applicable income taxes required by such a conversion. The funds continue to grow and in 2010, at age 62, you decide to withdraw those funds.
Will you be able to withdraw tax free since you pass the age of 59 ½?
You still haven't met the 5 year rule for that portion of your money which you the converted. You converted in 2007 and 2010 is only 3 yrs. You need to wait two more years before you can withdraw all the money tax and penalty free. The original contributions can still be withdrawn tax-free and penalty-free but not the investment gains.
Early Withdrawal Exceptions:
There other cases when you can withdraw investment gains from your Roth IRA without having to pay taxes and penalties that are specifically listed in the tax code. They are as follows:
1. IRA owner's disability. (This can be a very narrow definition, so don't consider a Roth IRA distribution for a disability until you review IRS Code Section 72(m)(7) and IRS Publication 590.)
2. IRA owner's death.
3. Withdrawals are a series of "substantially equal periodic payments" made over the life expectancy of the IRA owner.
4. Paying for unreimbursed medical expenses that exceed 7 1/2% of your adjusted gross income (AGI).
5. Paying medical insurance premiums after the IRA owner has received unemployment compensation for more than 12 weeks.
6. Paying the costs of a first-time home purchase (subject to a lifetime limit of $10,000).
7. Paying for the qualified expenses of higher education for the IRA owner and/or eligible family members.
8. Paying back taxes because of an Internal Revenue Service levy placed against the IRA.
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