Roth IRA accounts differ from other IRAs in that your contributions are made in after-tax dollars. If you follow the Roth IRA rules, your withdrawals of any earnings in the account can be tax-free. Thanks to this tax-free provision, Roth IRAs can be a powerful tool in creating long-term wealth.
Generally, to take advantage of the tax-free nature of a Roth IRA when taking distributions:
- You must be age 59½ or older.
- You must have had funds in the Roth IRA account for more than 5 years.
- You must understand what is being distributed (contributions, converted funds or account earnings).
- You must know your possible tax-free distribution options.
If you do not comply with these rules you could be subject to income tax and a 10% early withdrawal penalty. But wait! There are ways to avoid taxes and penalties on withdrawals.
- Plan around the 10% early withdrawal penalty. Prior to withdrawing funds, ask for help to ensure you know whether you will be subject to the early withdrawal penalty.
- Remember that contributions have already been taxed. The portion of an early distribution from a Roth IRA account subject to income tax is only the untaxed earnings on your contributions. Your basis (what you contributed) in the account can be withdrawn without tax implications.
- Keep separate accounts. The taxability of a withdrawal can be complicated. Are you withdrawing contributions, converted funds or earnings? How long have the funds been in the Roth IRA? Because Roth IRA distribution rules can be complex, if you convert funds from another retirement account into a Roth IRA, do so in a separate account. It will then be easier to understand the impact of a withdrawal from the account.
- Understand the rules for qualified early withdrawals. If you use the distributions for a qualified reason, you can avoid the early distribution penalty. Some of the more common qualified early withdrawals from a Roth IRA include:
- College. If you withdraw Roth IRA earnings to pay for college expenses, you will pay tax on the earnings withdrawn, but you will not be subject to the 10% early withdrawal penalty.
- First-time home buyer. Even if you have had your Roth IRA for less than five years, you can withdraw up to $10,000 in Roth IRA earnings tax-free and penalty-free if it is used to buy a first home.
- Account holder disability or death.
- Unreimbursed medical expenses that exceed your itemized deduction threshold.
- Substantially equal periodic payments. These must be made over the defined life-expectancy of the IRA holder using specific rules to avoid the early withdrawal penalty.
One of the best attributes of Roth IRAs is the lack of a minimum withdrawal requirement. Unlike traditional IRA rules, Roth IRA rules do not require you to take money out when you reach a certain age. As a result, your account can continue to grow tax free. In many cases, investors utilize this advantage as an estate-planning strategy. Heirs have the ability to withdraw the funds tax and penalty-free, meaning that they may inherit a greater amount of money net of taxes.
As with any financial strategy, knowing the ins-and-outs is critical to enjoying the full benefits of the Roth IRA. There are income limits and contribution limits to consider, in addition to evaluating the costs and benefits of pre-tax versus post-tax retirement savings. Wisdom Wealth Strategies provides expert retirement, tax, and investing advice to clients. If we can help you too, please be in touch.
Andrea L. Blackwelder, CFP®, ChFC, CDFA® and Joseph D. Clemens, CFP®, EA are the founders and partners of Wisdom Wealth Strategies. Their shared passion is simple: to bring financial empowerment, understanding, and peace-of mind to people who wish to improve their financial future, build wealth for their families, and achieve financial independence. Click here to find out more about how you can work with the Denver Financial Advisors at Wisdom Wealth Strategies.