The basic rules
Because Roth IRA contributions are made with after-tax dollars, you can withdraw the contributions tax and penalty free at any time. That's the simple part. But the beauty of a Roth is that the earnings can also be tax and penalty free. And that's where things can get more complicated.
The IRS makes a distinction between what they call qualified and nonqualifieddistributions. According to the 5-year rule, for a distribution to be qualified, or not taxable or subject to penalty, you have to have held your Roth IRA for a period of five tax years, and meet one of the following conditions:
- You must be at least 59½, or
- You use the money to pay for a first-time home ($10,000 lifetime cap), or
- You become disabled, or
- The distribution is made to a beneficiary or to your estate after you die.
Here are a couple of sample scenarios:
- Qualified distribution—Let's say you opened a Roth IRA in 2005 and have made yearly contributions amounting to $50,000. With your earnings, your account is now worth $54,000. Let's also say you turned 59½ in 2016. Because you meet both the 5-year holding period and the age qualifications, you won't owe any taxes or penalties.
- Nonqualified distribution—Now let's say you're only 45 (and you're not disabled or buying a first house). In this case, you'll be taxed on the $4,000 in earnings at your ordinary income tax rate. But that's not all. Because you're under 59½, and you don't meet the other conditions, you might also have to pay a 10 percent early withdrawal penalty on your earnings. I say might because, as with all rules, there are exceptions.
The exceptions
In general, if you withdraw money from your Roth IRA before you've met the 5-year holding period and/or before you reach 59½, not only is the earnings portion of the distribution taxable, but you could be subject to a 10 percent penalty on those earnings unless the distribution is used for one of the following exceptions:
- Qualified higher education expenses for yourself and/or eligible family members,
- Unreimbursed medical expenses that exceed 7½ percent of your adjusted gross income, or
- Health insurance premiums if you're unemployed.
You can also avoid the 10 percent penalty if the distribution is:
- Made in substantially equal periodic payments over the period of your life expectancy, or
- Due to an IRS levy of the qualified plan.
One factor in your favor is that the IRS also has rules about the order in which funds are taken out. Withdrawals are considered to first come from contributions (which are not subject to any holding period), then from Roth conversions, and lastly from earnings. So how much you're withdrawing and what percentage comes from earnings will also determine the extent of any taxes and penalties.
