There’s a big difference between traditional and Roth IRAs when it comes to getting at your money before retirement age. First, consider the rules for traditional IRAs.
Make no mistake: IRA money is different from funds you are saving on your own for, say, a child’s college education or a retirement cushion. You may think of those accounts as sacrosanct, but you know you can put your hands on the cash in an emergency.
It’s different with a traditional IRA. When you accept the tax breaks, you sign the government on as a partner—and a stern one at that. Dip into the account early—as far as the law is concerned, generally anytime before you’re 59 1/2 is early—and you’ll be hit with a 10% penalty for premature distribution. Take $5,000 out at age 50, for example, and you probably will be slapped with a $500 penalty. In addition, the full $5,000 will be included in your income for the year and taxed in your top tax bracket. (If you’ve ever made nondeductible contributions, part of the withdrawal would be penalty-free—the same percentage as the after-tax money in the account is of the total balance.) There are plenty of exceptions to the early withdrawal penalty:
There's a big gotcha in these exceptions. Although the 10% penalty is waived in all these circumstances, the money would still be taxed in your top bracket (except to the extent it was attributable to nondeductible contributions). With the first-time-home-buyer exception, then, as much as 40% or more of the $10,000 would go to federal and state tax collectors rather than toward a down payment. With the break for college costs, a big chunk of your IRA money could wind up at the IRS rather than at the bursar's office. Still, dodging the 10% penalty will ease the pain if you need your IRA money before age 59 1/2.
SPECIAL EXCEPTION FOR HURRICANE VICTIMS: As part of its efforts to aid victims of Hurricanes Katrina, Rita and Wilma, Congress has waived the 10% penalty for early plan withdrawals and will allow taxpayers to pay the taxes on such withdrawals over a three year period. To qualify for this break, your principal residence must have been in the areas struck by one of the three storms and you must have suffered an economic loss from the storm. If you qualify, up to $100,000 can be withdrawn from IRAs or other retirement plans penalty-free and the tax bill stretched out over three years. If you are able to restore the funds to your retirement account within three years, you can recover the taxes paid earlier by filing an amended return..
At first blush, Roth IRAs also threaten you with a 10% penalty if you cash in before age 59 1/2. And any withdrawal that is penalized will also lose tax-free status. It’s a painful double whammy. But the threat has been way overblown. As noted below, there are ways to get money out of a Roth tax- and penalty free at any age.
To understand the early-withdrawal penalty, you must begin with the definition of a "qualified distribution" from a Roth IRA, which is what the law calls a withdrawal that is tax- and penalty-free. To qualify, two tests must be met:
First, there’s the five-year rule. It holds that a Roth must be open for at least four calendar years after the year of your first contribution for you to qualify for tax- and penalty-free withdrawals. Say, for example, that you made your first contribution to a Roth sometime in 1998, the first year they were available. The earliest you could make a tax- and penalty-free withdrawal would have been in 2003. Note that a Roth doesn’t have to be opened for five full years to pass this five-year test. You could have opened a Roth for 1998 on April 15, 1999, for example, under the rule that allows you to make contributions up to the due date of the tax return for the year involved. That would start the clock ticking in 1998, so once four calendar years have passed—1999, 2000, 2001 and 2002—payouts beginning in 2003—less than 45 months after the account was opened—could be tax- and penalty-free.
They could be, that is, if the payout also meets one of the following conditions:
Although it looks like your money is locked up tighter in a Roth than in a traditional IRA — since tapping the account before age 59 1/2 can mean not only a 10% penalty, but also a tax bill on earnings that would otherwise be avoided — read on. Congress decided to allow Roth IRA investors to reclaim contributions at any time and at any age, without tax or penalty. And, the lawmakers said that the first money coming out of Roth IRAs will be considered contributions. Only after you have withdrawn an amount equal to all of your contributions tax- and penalty-free do you have to begin to worry about the early withdrawal penalty.
Say, for example, that you contribute $4,000 a year for five years and, at the end of the fifth year, the account is worth $30,000. Regardless of your age or how you spend the money, you could withdraw $20,000 (the total of your five contributions) tax- and penalty-free.
For purposes of this rule, all your Roth IRAs are treated as one. So, even if the $30,000 in this example was divided evenly among three accounts, you could cash in two accounts—for a total of $20,000—without worrying about tax or penalty. The fact that you were actually pulling earnings as well as contributions out of the accounts doesn’t matter.
Take a deep breath. . .and try to forget anything you've heard about how the early-withdrawal penalty applies to amounts converted from traditional IRAs to Roth IRAs. There has been so much misinformation surrounding this that the odds are good that anything you've heard is wrong. Here's the scoop:
Money that is converted to a Roth must generally stay in the account long enough to meet the five-year test — that is, for four calendar years after the year of the conversion — to avoid the 10% penalty. Example: In 1998, a 30-year-old converted $20,000 to a Roth IRA. The five-year test was met at the end of 2002, so at age 34 the investor could withdraw the $20,000 tax- and penalty-free. (It's tax-free, of course, because taxes had to be paid at the time of the conversion.) If you convert a traditional IRA to a Roth in 2006, you can tap the account tax- and penalty-free starting in 2011, regardless of your age.
If you pull out converted amounts before meeting the five year test, however, the money would be hit with the 10% penalty. . .maybe.
We say maybe because exceptions apply. For example, if you are at least 59 1/2 at the time of the withdrawal, it would not be penalized — no matter how briefly the amount had been in the Roth. And, the penalty is also waived if you meet any of the other exceptions that apply for traditional IRA purposes. That means, for example, that converted amounts can be withdrawn at any time, penalty-free, if the money is used for a first-time home purchase (up to the $10,000 limit) or to pay for college expenses.
All this talk about withdrawing "converted" amounts demands a look at the ordering rule that controls what money comes out of a Roth IRA when. Here, too, Congress is generous.
So, how are Roth earnings taxed?
One more thing about the five-year test. When it comes to annual contributions, there is only one five-year test. If you open your first Roth in 2006, you pass the five-year test in 2011. Even if you open another Roth with a 2007 contribution — at a different mutual fund, say — you'll pass the five-year test for that account in 2011, too. When it comes to conversions from traditional IRAs, however, each conversion has its own five-year test.
How do you keep track of what's what, particularly since in most cases you won't report annual Roth contributions on your tax returns? This could be a real pain over the decades that you might be contributing to or tapping into Roth accounts. You will get some help from the IRS. The tax agency demands that IRA sponsors report to you each year's annual contribution to a Roth and any amounts you convert from a traditional IRA to a Roth. You'll get that report on Form 5498. (Watch for it in May or June, not before the April 15 deadline like most other tax documents.) Plan to file away those forms for several years until it becomes clear how IRA sponsors will track contributions and conversions for you.
When it comes to outgo from your Roth, you will report distributions on Form 8606. You'll need to keep copies of that form to show how much has been withdrawn so you know when you begin dipping into earnings. Once you pass 59 1/2 and meet the five-year test, your paperwork gets easier: All your withdrawals are tax-free.
What if you have multiple Roth IRAs, as you may well have after a few years of spreading your money among different mutual funds, perhaps, or at brokerages? You can have as many as you want (watch the fees), but as far as the law is concerned, you have just one Roth. All accounts are aggregated when it comes to figuring whether you are withdrawing contributions, converted amounts or earnings.
Say, for example, that after four years you have three Roth accounts — two to which you have made a total of $8,000 of contributions and one which you started with a $10,000 conversion from a traditional IRA. And, you withdraw $5,000 from the Roth begun with the conversion. Since all Roth accounts are blended together, as far as the law is concerned that $5,000 is a return of part of your annual contributions — and comes to you tax- and penalty free, regardless of your age or how long any of the Roth IRAs have been around.
In most cases 100% of what you withdraw from a traditional IRA is taxable. However, if you have made nondeductible contributions, then part of each withdrawal is tax-free. The tax-free part is basically the same percentage of the withdrawal as your non-deductible contributions are of the total amount in your IRAs. When figuring this ratio, you have to consider all your IRAs as one.
Once you reach age 59 1/2, the threat of the 10% penalty disappears. In most cases 100% of what you withdraw from a traditional IRA is taxable. However, if you have made nondeductible contributions, then part of each withdrawal is tax-free. The tax-free part is basically the same percentage of the withdrawal as your non-deductible contributions are of the total amount in your IRAs. When figuring this ratio, you have to consider all your IRAs as one.
You can withdraw as much from your traditional IRAs as you want, penalty free. Cash coming out of the account is taxable in your top tax bracket, except to the extent that it represents a return of nondeductible contributions. The tax deduction you take when you put money in really just puts off the tax bill on the deposit until the money comes out. Also, when tax-deferred earnings are withdrawn, the IRS finally gets a crack at them.
You can cash in your IRA all at once, but doing so could subject you to an enormous tax bill. You'll probably do better tax-wise by taking out as little as necessary each year. Not only does that hold down the tax bill you owe each year, but it also leaves more money in the tax shelter to enjoy continued tax-deferred growth.
But this tax shelter does not last forever.
Traditional IRAs were created to help you accumulate money for your retirement not build up a pile of money for your heirs to inherit. So, the law demands that you begin pulling money out when you reach age 70 1/2. The minimum withdrawal schedule is designed to get all your money out and taxed by the time you die, or at least by the time your designated IRA beneficiary dies. If you don't take out the minimum required each year, the IRS will claim 50% of the amount you fail to withdraw.
The first mandatory distribution must be made by April 1 following the year you reach age 70 1/2.
In a stunning development in 2001, the IRS greatly simplified the method for figuring minimum withdrawals. And, not only are the new rules blessedly simpler than in the past, they are actually beneficial for the vast majority of taxpayers by allowing them to slow down withdrawals (if they want to) and stretch out this tax shelter. Minimum withdrawals are based on your life expectancy and, until 2001, the life expectancy of the oldest beneficiary named on the account. If you had several IRAs, the minimum withdrawal from each was based on the amount in the account at the end of the previous year and your age, or the ages of you and your oldest beneficiary. It was, to be frank, a real pain.
But now, minimum withdrawals are based on joint life expectancies that assume you have a beneficiary who is ten years younger than you are. You use this method even if you don't have a named beneficiary. Besides being simpler, this also stretches out withdrawals for anyone whose beneficiary is less than ten years younger, as well as those who haven't named a beneficiary. (You should name a beneficiary, though, because a named beneficiary has more flexibility on using the account than someone who inherits an IRA under a will.)
Under the new rules, if you turn 70 in the year you reach 70 1/2 (in other words, your birthday falls before July 1), the life expectancy you use for figuring the first mandatory withdrawal is 27.4. You would add up the total in all your IRAs at the end of the previous year, divide that amount by 27.4 and, voila, you know how much you have to withdraw.
Once you determine the minimum withdrawal it's up to you which account or accounts to tap into to meet the minimum distribution requirement. Say, for example, that you have five accounts and you determine you need to withdraw a total of $15,000. If you want to take the full amount out of a single IRA say the one returning the lowest return on your investment that's okay. You don't have to take money out of every IRA you own. Also remember that you can always take MORE than the minimum.
There is one exception to the "everybody uses the same life expectancy" rule. If your beneficiary is your husband or wife — and he or she really is more than ten years younger than you are — you can use an even longer life expectancy to figure your minimum withdrawals. That would let you stretch them out even more and keep the tax shelter going.
As noted earlier, in the year you reach age 70 1/2, you have until April 1 of the following year to actually make the first mandatory withdrawal. If your 70th birthday falls in the first half of 2007, for example, you will be required to make a withdrawal for 2007. But you have until April 1 of 2008 to do it. Putting off the withdrawal would let you postpone reporting the amount on a tax return until you file your 2008 return in 2009.
After the first year, required withdrawals must be made by December 31. So, if you delay your first withdrawal until April 1, you will be required to take two distributions during that calendar year. If that pushes you into a higher tax bracket, delaying the first payout could be a mistake.
If you have a good reason for failing to make the mandatory withdrawal say the IRA sponsor provided you with incorrect balance information or you didn't understand the life-expectancy method the IRS can (but doesn't have to) excuse the 50% penalty on the amount you should have withdrawn. You figure any penalty due on Form 5329, Return for Individual Retirement Arrangement and Qualified Retirement Plan Taxes. If you think you have a good enough excuse to get the IRS to waive the penalty, attach your explanation to the form.
The life-expectancy tables also play a key role in a valuable exception to the 10% penalty for traditional IRA withdrawals prior to age 591/2. The penalty is waived if the withdrawal is part of a series of roughly equal payments tied to your life expectancy. If you have a substantial amount in your IRA accounts, this rule may permit you to claim penalty-free withdrawals of thousands of dollars a year. For this rule, you use your real estimated life expectancy, not the joint life expectancy that assumes you have a beneficiary ten years younger than you are.
To use this loophole to get at your IRA early, you must stick with the lifetime payout schedule for at least five consecutive years and until you're at least 591/2. Violate either of those requirements and the 10% penalty would be applied retroactively to your pre-591/2 withdrawals.
Here's an example of how the rule works. If you are 55 and have no IRA beneficiary, your life expectancy is 29.6 years. Assume you have a total of $100,000 in your IRA accounts. Spreading that amount over more than 29 years would put your annual withdrawal at just $3,378.
Fortunately, the IRS allows you to take a reasonable interest rate into account when figuring your penalty-free payouts. Unfortunately, these days the acceptable rate is paltry. Unlike in the past, when taxpayers could set their own "reasonable rate", the IRS now sets the rate. In the fall of 2006, it was just 6.03%.
If you start such life-expectancy-based withdrawals at age 55, by the time you reach 60 you will be free to change the withdrawal schedule—you will have met both the five-year and the age 59 1/2 requirements. From then on you can take out more or less money without worrying about the recapture rule.
While such pre-59 1/2 withdrawals dodge the 10% penalty, the money pulled out of the traditional IRA would be taxed, except to the extent it is a return of nondeductible contributions.
If your aim is to hold down how much you withdraw under the life-expectancy exception, note that when figuring how much to withdraw you do not have to consolidate all your traditional IRAs (and your Roth IRAs don't count at all).
Things are a lot easier with Roth IRAs, thank goodness.
Once you reach age 59 1/2 and the account passes the five-year test, you can take as much or as little from your account as you need—all tax- and penalty free.
What if you open a Roth for 2006 (and you have until April 16, 2007, to make a 2006 contribution) and you're already older than 59 1/2? You need to wait until at least 2011 to take tax-free withdrawals of earnings. Remember, you have to wait until four calendar years have passed after the year in which you made your first contribution. But you could reclaim your contributions at any time tax- and penalty-free.
You don't have to worry about a minimum distribution schedule, either. You never have to take a dime out of your Roth IRA, at age 70 1/2 or any other age. Unlike traditional IRAs, a Roth IRA can be used to build up a stash of cash to leave to your heirs.
What if the IRA owner dies while there's still money in the tax shelter?
First, the 10% early-withdrawal penalty does not apply to distributions to beneficiaries. The beneficiary of the account can cash in the IRA without worrying about that penalty, regardless of how old the owner was at the time of death or how old the beneficiary is when he or she claims the cash.
The potential problem, however, is that the money pulled out of a traditional IRA is taxable to the beneficiary (except to the extent that it represents nondeductible contributions). This is a major-league exception to the general rule that inheritances are tax-free. And, it could create a substantial tax bill if the IRA is cashed in all at once. The heir may be better off leaving the money in the IRA to continue taking advantage of the tax shelter. Of course, the IRS has something to say about that, too.
But here, too, changes made by the IRS in 2001 greatly simplify things. In the past, the rules for the beneficiary depended on the age of the IRA owner when he or she died. Now, that doesn't matter. If the beneficiary is the widow or widower, he or she may claim the IRA and put off distributions until age 70 1/2, at which time he or she would use the joint life expectancy rules discussed earlier. Otherwise, beneficiaries can stretch payouts over their own life expectancies. If no beneficiary is named on the account — so the IRA passes to its new owner under a will or the state's intestate rules — the account must be cleaned out within five years. (Name a beneficiary!)
If you're going to inherit an IRA, pray that it's a Roth. The money will come to you tax-free. This is a major difference between the two varieties of IRAs.
Even though the government has no stake in the account at the time of the owner's death, Congress doesn't want the heir to perpetuate the tax shelter forever. As for how quickly you must clean out an inherited account, if you are the widow or widower of the IRA owner, you can claim the account as your own. In that case there would be no required withdrawals. Otherwise, a named beneficiary must withdraw everything from the IRA within five years of the death of the owner or to begin withdrawals within one year of the death of the owner, based on the life expectancy of the beneficiary. If no beneficiary is named, the only choice is to cash out the entire IRA within five years.