What’s the Roth IRA early withdrawal penalty?

Typically, it’s a 10% penalty on investment gains withdrawn from your Roth account prior to age 59 1/2.

This means that unless you meet one of the early withdrawal exceptions, your withdrawal must meet two criteria in order to be classified as a qualified distribution which is tax-free and penalty-free.

What are the two criteria?

That you’ve…

1) Reached age 59 1/2
2) Funded your account for at least 5 years

You must meet both requirements before you can confidently withdraw funds tax-free and penalty-free from your Roth. Of course, there are exceptions.

So let’s take a closer look at the rules…

Roth IRA Distributions After Age 59 1/2

Any distributions of investment gains taken from your Roth IRA prior to age 59 1/2 are considered early withdrawals.

Other than the exceptions highlighted below, early withdrawals are subject to income taxes as well as the Roth IRA early withdrawal penalty.

Notice the phrase “of investment gains.” That’s important…

Why?

Because you need to differentiate between your original Roth contribution and the earnings (investment gains) which result from that contribution.

Original contributions can be withdrawn at any time tax-free and penalty-free.

After all, your contributions are non-deductible, so you funded your Roth IRA with after-tax funds.

Because you’ve already paid income taxes, you shouldn’t have to pay a second tax bill just to gain access to your money.

But investment gains are a different story…

Think about it… If you have investment gains in a regular taxable brokerage account, those gains are subject to taxation. And we both know how much the government loves to tax your money.

So if you make an early withdrawal of investment gains from your account, the government is going to want its share.

So remember, you can withdraw your original Roth IRA contribution at any time tax-free and penalty-free.

But if you withdraw any investment gains prior to age 59 1/2, then you’ll owe income taxes and a 10% early withdrawal penalty on those funds.

Find that hard to follow?

Here’s an example…

At age 25, you open a Roth and contribute $3,000. You never make any additional contributions.

Fifteen years later, you decide to close the account. It’s now worth $10,000.

How much of that $10,000 do you get to keep?

Well, in closing the account early, you don’t owe any taxes or penalties on $3,000 of the $10,000.

Why?

Because you can withdraw your original contribution any time both tax-free and penalty-free.

But the remaining $7,000 is considered an investment gain. As a result, it’s subject to income taxes and a 10% Roth IRA early withdrawal penalty.

So assuming a tax rate of 25%, you owe $1,750 in income taxes as well as a $700 early withdrawal penalty… Meaning $2,450 of the $10,000 goes to taxes and penalties.

That leaves you with a grand total of $7,550 after closing your account.

So remember…

An early withdrawal of your original contribution is always…

Tax-free and penalty-free.

But an early withdrawal of your investment gains prior to age 59 1/2 is subject to…

A 10% Roth IRA early withdrawal penalty as well as applicable income taxes.

The 5 Year Rule

Even if you reach age 59 1/2, you still need to meet one more requirement before you can withdraw funds tax-free and penalty free.

What requirement?

It’s called the 5 year rule.

And as a general rule, it means your Roth IRA needs to be funded for at least 5 tax years before you can make tax-free and penalty-free withdrawals.

Need an example?

Let’s say at age 59 your accountant informs you that it’s a good idea to convert your Traditional IRA to a Roth. You do that in the year 2007, paying the applicable income taxes required by such a conversion.

The funds continue to grow and in 2010, at age 62, you decide to withdraw those funds.

Can you do so tax-free and penalty-free?

No.

Even though you’ve reached and surpassed age 59 1/2, you still haven’t met the 5 year rule for that portion of your money which represents the conversion. And you need to meet the 5 year rule before you can withdraw your investment gains tax-free and penalty-free.

The original contributions can still be withdrawn tax-free and penalty-free.

But the investment gains need to meet the 5 year rule before they can be withdrawn tax-free and penalty-free.

In this case, only four tax years have passed. 2007… 2008… 2009… and 2010.

You meet the requirements of the 5 year rule and are able to withdraw funds in the January following the fifth tax year.

In this case, 2011 is the fifth tax year. So January 2012 is when you can start to withdraw investment gains both tax-free and penalty-free from your account.

Early Withdrawal Exceptions

By now we’ve learned that if your account meets the 5 year rule and you’ve reached age 59 1/2, then you can withdraw funds tax-free and penalty-free.

But are there other cases when you can withdraw investment gains from your Roth without having to pay taxes and penalties?

You bet.

Author Bio: For detailed information about the early withdrawal exceptions and more information on the Roth IRA early withdrawal penalty, visit Britt Gillette’s website, Your Roth IRA, a site focused exclusively on helping people with self-directed Roth IRAs.

Category: Finances
Keywords: roth ira early withdrawal penalty, roth ira early withdrawal