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4 Penalty-Free Ways to Use a Roth IRA Before Retirement

You probably know that using a Roth IRA to save for retirement is a smart move that also cuts your taxes. But what you may not know is that unlike other types of retirement accounts, you can spend it before retirement. Laura explains the unique flexibility of a Roth IRA and covers 4 ways you’re allowed to make penalty-free withdrawals from a Roth IRA to spend anytime you like.

By
Laura Adams, MBA,
April 19, 2017
Episode #494

Page 1 of 3

4 Penalty-Free Ways to Use a Roth IRA Before RetirementI’ve written about the Roth IRA many times before, with good reason. Hands down, it’s one of the best places to invest for the long-term because it’s one of the only accounts that gives you tax-free money in retirement. But what you may not know is that unlike other types of retirement accounts, you can spend it before retirement without having to pay taxes or an early withdrawal penalty.

Owning a Roth IRA and really understanding all the rules, is another matter. So, in this post, I’ll explain the unique flexibility of these accounts and 4 ways you’re allowed to make penalty-free withdrawals from a Roth IRA to spend before you retire. 

Free Resource: Retirement Account Comparison Chart (PDF download)  - get this handy, one-page resource to understand the different types of retirement accounts.

In How to Make Kids Rich by Investing in an IRA, I discussed the eligibility rules and benefits of using a Roth IRA to give minors a financial head start in life. A Roth IRA is available to anyone, no matter your age, who has earned income up to certain annual limits (see the article about making kids rich for more details).

With a Roth IRA, your contributions are not tax-deductible, which means you make them on an after-tax basis. Then your investment earnings grow completely tax free—that’s a huge benefit!

Because you pay tax upfront on Roth contributions, you’re allowed to withdraw them at any time for any reason. You don’t owe the IRS additional tax or penalties on that portion of your account. That means you can take out an amount that equals, but doesn’t exceed, the total amount of your original contributions, with no problems.

Because you pay tax upfront on Roth contributions, you’re allowed to withdraw them at any time for any reason.

However, where things get a little confusing is for the earnings portion of your Roth account. The investment growth that your contributions creates is subject to tax in certain situations. There are restrictions on withdrawals of earnings because you haven’t paid tax on them yet.

Also, the IRS says earnings must be distributed from a Roth IRA last. So, how much you want to withdraw and the percentage that would come from earnings determines your potential taxes and penalties.

Let’s say you contributed $5,000 to a Roth IRA every year for 10 years and have a current account balance of $56,000. Your total after-tax contributions add up to $50,000 ($5,000 x 10 years) and your pre-tax earnings total $6,000.

You could withdraw up to $50,000 from the account with no restrictions, tax liability, or penalties. But whether you could do the same with the $6,000 in Roth IRA earnings depends on 3 factors:

1.    How long you’ve held or owned the account.

2.    Your age.

3.    How you plan to spend the earnings you withdraw.

See also: What's the Difference Between a Roth 401k and a Roth IRA?

How Your Holding Period Affects Roth IRA Withdrawals

Roth accounts offer so many great advantages that the IRS wants to make sure you don’t abuse them. The hurdle you must get over before you’re eligible to withdraw earnings tax free is called the Roth 5-year rule.

It’s a waiting period that begins on January 1 of the year your first Roth IRA contribution was made for. It could be different than the actual year you contributed because you have until April 15 to make an IRA contribution for the previous tax year.

Even if you never put another dime into a Roth IRA after your initial contribution, the holding period clock starts ticking and you’ll satisfy the requirement once 5 tax years have passed. And making new contributions doesn’t reset the clock.

Also, if you have multiple Roth IRAs, they’re aggregated together under this rule, which means you get credit for the oldest one. When you satisfy the 5-year rule once, it’s satisfied for good, assuming you keep the account open.

If you don’t meet the 5-year holding period and withdraw earnings from a Roth IRA, they’ll be included in your taxable income for the year. Plus, you may be subject to an early withdrawal penalty, depending on your age.

If you don’t meet the 5-year holding period and withdraw earnings from a Roth IRA, they’ll be included in your taxable income for the year. Plus, you may be subject to an early withdrawal penalty, depending on your age.

See also: Can You Contribute to a 401k and an IRA in the Same Year?

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