The Early Withdrawal Consequences on a Roth IRA

There might come a time when you’ll find yourself in a financial bind and  may not have any other options but to tap your retirement plans.

The IRS considers any withdrawals from your retirement plan an early withdrawal or distribution if made before you reached the age of 59 1/2 years.

In general, the early distributions from most retirement plans will be included in your taxable income. In some cases, this may put you in a higher tax bracket and you may end up paying at a higher tax rate.

In addition to this, you will have to pay a 10% early withdrawal penalty unless you meet the IRS exemption criteria.

Thinking of taking money out of your Roth IRA before reaching the age of 59 1/2 years?

Before you do, you should understand the various rules in order to minimize the tax consequences of early withdrawals on a Roth IRA.

The one unique distinction of the Roth IRA among other retirement plans is that the contributions to the plan are made using your after-tax dollars. The key advantage is you won’t get taxed at all when you start receiving distributions come retirement time. However, it is a different story if you are making an early withdrawal.

Tax Consequences of An Early Withdrawal

• Original Contributions – Unlike the traditional IRA, there are no tax and penalties imposed when you are withdrawing the original contributions on the Roth IRA. This is because you already paid taxes on it so the IRS does not care. You can take the money at anytime for any reason tax free. This is similar to putting your money in a regular savings account without any restrictions on the withdrawals.
• Earnings – when you make an early withdrawal on your earnings, you may have to pay taxes and penalties on it unless you meet the conditions for the tax-free exemption as discuss later on this article.

How do you know if your withdrawals are return of contributions or earnings?

On a Roth IRA, it is important to know which ones are classified as your original contributions, conversions or earnings in order to determine if the withdrawals are taxable or not. One big question that most people ask is how do you determine which one is which?

The IRS does not want to make it complicated so they made a rule that when you make a withdrawal, it will be treated as withdrawals of your original contribution first then followed by the conversions (from traditional IRA or other qualified plans), if you made any.  The only time that it will be classified as Roth IRA earnings is after you have exhausted the balance of your original contribution and conversion or roll-over amounts.

• Example 1: You have just opened your Roth IRA five years ago and have contributed a total of $25,000. In addition, your Roth IRA earned $5,000 putting your Roth IRA balance to $30,000. This year, you have made an early withdrawal of $10,000 so you can use it to purchase a brand new car. Because you still have $25,000 of your original contribution in the account, the full $10,000 withdrawals will just be treated as return of your original contribution. Thus, you won’t get taxed nor penalized even if the reason for the withdrawal is not one of the exceptions as discussed later.
• Example 2. Same situation as Example 1 but instead of withdrawing just $10,000, you decided to withdraw the whole $30,000 Roth IRA balance in your account to purchase the car. In this case, the withdrawals will be classified as $25,000 return of your contribution and $5,000 earnings. You do not have to pay taxes and penalties on the $25,000. However, you will be taxed and penalized on the $5,000 withdrawal of your earnings because it did not meet the exceptions discussed on the next section.

Exceptions to the Early Withdrawal Penalty on Roth IRA Earnings

Once your withdrawals have been classified as earnings, you need to determine if you are going to pay taxes on the earnings. There are two requirements that you need to meet before your earnings withdrawal qualifies for the exemption (hence the term “Qualified Distribution” as defined by the IRS): the holding period and the use test.

However, you need to meet both requirements for it to be called a “Qualified Distribution.“

Holding Period Test – In order for you to avoid paying the 10% early withdrawal penalty and the regular income tax, you must make the withdrawals after the 5-year period beginning with the first taxable year for which you set-up your Roth IRA and made the first contribution.

The way it works is the clock starts on the the beginning of the year and not on the day you actually started making your first contribution. As an example, if you began making a regular Roth IRA contribution on July 1, 2009, the 5-year holding period begins on January 1, 2009 and not on July 1, 2009. The same rule applies for the conversion. If you converted your traditional IRA on May 12, 2007, the holding period starts on January 1, 2007. So in essence, you have been given more time if you made your first contribution in the middle of the year.

Use Test – In addition to this holding period, you must also meet one of the following conditions: