Understand Early Withdrawal Rules for Roth and Traditional IRAs
Withdrawing funds from an IRA typically incurs taxes and penalties, but fortunately, there are certain situations when you can pull money without paying either. Understanding the rules of early withdrawals can be the difference of keeping more money in your pocket or having to fund a hefty tax bill.
The main distinction when discussing early withdrawals is between Roth IRAs and traditional IRAs. When planning your IRA withdrawal, it is important to know the rules and exemptions for each type of account.
Traditional IRAs – Tax and Penalties
When referencing traditional IRAs, it is important to remember that all distributions are taxed as ordinary income in the year presented. Additionally, taking money out before the age of 59 ½ carries a 10% early withdrawal penalty from the IRS. Fortunately, there are some exceptions to the penalty – such as making a withdrawal due to a disability or to pay unreimbursed medical expenses – that allow the funds to be removed from an IRA without penalty.
Roth IRAs – Tax-Free Withdrawals
In comparison to traditional IRAs, Roth IRAs usually deliver bigger long-term benefits. Unlike traditional IRAs, contributions to Roth IRAs are made with post-tax income and allow growth to occur without the pressure of taxes. If certain qualifications are met, funds can be withdrawn from a Roth IRA tax free – the money has already been taxed full at the time of contribution and the qualified distributions allowed are tax free. Even if you have not been contributing to your Roth IRA for five years, early withdrawals can still be made penalty free. However, taxes will still be imposed on the earnings portion of the payments.
Planning Wisely for Your Withdrawal
When it comes to wise investing, planning for every eventuality is key to a successful portfolio. The same is true when planning for withdrawals from an IRA. Knowing the various rules, qualifications, and penalties associated with early withdrawals from a Roth or traditional IRA can make all the difference between cutting your tax bill or paying a hefty sum. Though early withdrawals from an IRA may be necessary, be sure to understand the applicable rules and regulations before cashing out.
Do I Pay Capital Gains and Penalty on Early Roth IRA Withdrawals?
Withdrawing funds from a Roth IRA before you turn 59 1/2 can sometimes be costly. The Internal Revenue Services (IRS) applies a 10 percent penalty for early withdrawals. On top of the penalty, your distributions will also be subject to taxes. If you are under the age of 59 1/2 and planning to take a distribution, understanding the rules and how to best limit your early withdrawal penalty is important.
Taxes and Penalties for Early Withdrawals
If you withdraw money from your Roth IRA before the age of 59 1/2, you may be subject to a stiff 10 percent penalty on the amount of the withdrawal. In addition, the IRS will impose taxes on the earnings portion of the withdrawal. Depending on your tax bracket, the taxes could range from 10 to 39.6 percent. All taxes and penalty must be paid by April 15 of the year after the withdrawal was made.
If you have invested in a Roth IRA, you can avoid the 10 percent penalty under certain circumstances. You will not be subject to the 10% penalty and earnings taxation as long as your withdrawals don’t exceed your payment amounts. This is referred to as taking a qualified distribution. There are several instances where a qualified distribution would be allowed, such as for disability, death, or if you are using the money to pay for qualified medical bills or educational costs.
Five Year Rule
To take a tax-free distribution, the money must stay in the Roth IRA for five years after the year you make the conversion. If you withdraw before then, the distributions are subject to the 10 percent penalty. The five year rule is determined from the first year you make a qualified IRA contribution. You must wait five calendar years, as this rule has nothing to do with the actual calendar year.
Additional Tax Penalty
The 10% additional tax applies to the part of the distribution that you have to include in gross income. It’s in addition to any regular income tax that’s due, such as on wages or income earned from investments. The 10% penalty does not apply to any portion of the Roth IRA conversion that is not included in the gross income.
Early withdrawals from a Roth IRA can have long-term repercussions. Understanding the rules and working to avoid the stiff 10% penalty is essential for investors planning to take a distribution early. Knowing your options and how to apply for a qualified distribution can help you meet your financial goals.