Deductible traditional IRAs offer tax deductions on contributions, as well as the tax-deferred growth that allows these accounts to take full advantage of compounding interest. Withdrawals from traditional IRAs are taxed as regular income, and the tax rates are based on your tax bracket for the year in which you make the withdrawal. Roth IRAs, on the other hand, do not offer tax deductions on contributions, as contributions to the account must be after-tax. But in exchange, Roth IRA account owners are offered not only the same tax-deferred growth on their assets but also tax-free distributions and withdrawals. Here’s how Roth IRA withdrawals work, including some rules and regulations.
Tax-Free Qualified Roth IRA Withdrawals
Provided you have reached at least the age of 59 1/2 and have had your Roth IRA account open for at least five years, all of your Roth IRA withdrawal is tax-free. The IRS calls this a qualified distribution.
Additional Qualifying Criteria for Tax-Free Withdrawals
Though being under age 59 1/2 and meeting the five-year requirement is perhaps the most common combination of criteria for taking a qualified distribution from a Roth IRA, there are several other scenarios in which withdrawals are considered qualified and, therefore, are tax-free:
If you are disabledIf the withdrawal is paid out to your beneficiary or your estate after your deathIf the withdrawal meets the IRS “first home” requirements (up to a $10,000 lifetime maximum)If you were affected by a qualified disaster (available in certain years)
Exceptions to the Early Withdrawal Penalty
Some types of withdrawals, though not qualified distributions, are exceptions to the 10% early distribution penalty. Non-qualified distributions associated with these exceptions are penalty-free, but earnings remain taxable. Penalty-free exceptions include:
If the withdrawal is used to pay for health insurance while unemployed or if unreimbursed medical expenses that are more than 7.5% of your adjusted gross income for the yearIf the distribution is made in substantially equal periodic payments
Tax-Free ‘Return of Basis’ Roth IRA Withdrawals
Since no Roth IRA contribution is ever tax deductible like a traditional IRA, most Roth IRA withdrawals will not be taxed. There is no tax due on any Roth IRA withdrawal if the total amount you withdraw is less than the amount you have previously contributed, no matter your age. For example, if, over several years, your annual contributions total $20,000 and you subsequently withdraw $5,000, none of your withdrawal will be taxable as it is considered a return of your original contribution. That said, there are a few scenarios in which you may be assessed an early distribution tax as a penalty on a Roth IRA withdrawal.
Penalized Roth IRA Withdrawals
Using the same example scenario as above, if you were to withdraw more than the $20,000 you had already contributed to your Roth IRA, meaning that you were also withdrawing earnings prior to reaching age 59 1/2, part of your withdrawal would be subject to taxes and a 10% tax for early distributions. The same would be said for any Roth IRA withdrawals above your basis (contributions) within the first five years of contributing to the account. This rule is colloquially known as the five-year rule. To make matters more complicated, Roth IRA conversion assets follow their own separate timeline for the five-year rule. If Roth IRA funds are added via a Roth IRA conversion, these funds specifically must meet the five-year rule themselves. As such, if you convert a Roth IRA and then take some of those converted monies the next year, your withdrawal would be taxable.
The 10% Early Distribution Penalty
In addition to the regular income tax, a 10% early distribution penalty is generally assessed on distributions that are made if the account holder has not yet reached age 59 1/2. However, the 10% early distribution penalty will only be assessed on withdrawals that are taxable. As such, any withdrawals that are returns of basis aren’t subject to the early distribution penalty, even if the taxpayer is under 59 1/2.
