There’s a big difference between withdrawing funds from a traditional IRA and withdrawing funds from a Roth IRA.
If you withdraw money from your traditional IRA and you’re younger than age 59 1/2, you’ll be subject to a 10% early-withdrawal penalty unless you qualify for an exception.
Example: You’re age 51 and you withdraw $10,000 from your traditional IRA. Since you don’t qualify for an exception, you’ll incur a $1,000 penalty on that withdrawal and the amount will be subject to tax. If you’re in the 25% tax bracket, this means that you’ll pay $2,500 in taxes. If you made any nondeductible contributions, however, part of the withdrawal would be tax-free.
Exceptions to the 10% early-withdrawal penalty include:
Death. If the IRA is distributed after the death of the owner, there is no penalty. It doesn’t matter how old the IRA owner was at the time of death, or the age of the beneficiary.
Disability. There is no penalty if you become permanently disabled. You must be unable to do any substantial gainful activity, and your disability—either mental or physical—must be expected to last longer than a year or lead to death.
Medical bills. If you use money that you withdraw from an IRA to pay medical bills that exceed 7.5% of your adjusted gross income (AGI), you won’t pay a penalty.
Example: Your AGI is $100,000 and you withdraw $10,000 from your IRA to pay medical bills. Since 7.5% of your AGI is $7,500, $2,500 of the amount that you withdrew ($10,000 - $7,500) won’t incur the 10% early-withdrawal penalty.
Medical insurance. You also won’t pay a penalty if you withdraw money from your IRA to pay for medical insurance when you’re unemployed. To qualify for this exception, you must receive unemployment compensation for at least 12 consecutive weeks. If you’re self-employed and your business is defunct, you can also qualify for this exception.
Payments over life expectancy. There is no penalty if the IRA distribution is part of a series of substantially equal payments over your life, or over the lives of you and your beneficiary. These withdrawals must last for at least five years and until you are 59 1/2 to avoid the penalty.
First home purchase. You can withdraw up to $10,000 (lifetime limit) from an IRA and use it to help pay to buy, build, or rebuild a first home for yourself, your spouse, your children or grandchildren, or your parents without incurring a penalty. Although the lifetime limit is $10,000, you and your spouse can each withdraw $10,000 from your IRAs—for a total of $20,000. To qualify for the exception, you must use the money within 120 days from the date that you withdrew it.
College bills. If you use the money that you withdraw to pay higher-education expenses for yourself, your spouse, a child, or a grandchild, you won’t pay a penalty. Qualified expenses include tuition, fees, and room and board for post-secondary education, including graduate work. The amount that you can withdraw is unlimited.
It’s important to remember, though, that the distribution is still subject to tax, and it could be taxed at a rate as high as 35% depending upon your tax bracket.
If you satisfy the requirements, qualified distributions are tax-free. A qualified distribution is any payment or distribution from your Roth IRA that meets the following requirements.
You make the withdrawal after the 5-year period beginning with the year in which you made your first contribution. To pass this test, the account doesn’t have to be open 5 full years. The reason for this is that you can make contributions to an IRA up to the due date of your tax return (usually April 15) for a particular tax year. For example, if you opened a Roth IRA on April 15, 2003 for the 2002 tax year, 2002 counts as the first year. This means that you can start making tax-free withdrawals in 2007.
One of the following conditions applies:
The withdrawal was made after reaching age 59 1/2;
The money was withdrawn after your death;
The withdrawal was made after you became disabled;
The money (lifetime limit is $10,000) was used to help buy, build, or rebuild a first home for you, your spouse, your children or grandchildren, or your parent; or
The money (no limit) was used to pay higher-education expenses for yourself, your spouse, a child, or grandchild.
You can withdraw your contributions at any time and at any age and incur no penalty or tax (Roth IRA contributions are not tax deductible). Once you have withdrawn an amount equal to all of the contributions that you made, the earnings will be taxable if the distribution isn’t a qualified distribution.
Example: You contribute $4,000 to a Roth IRA each year for four years, for a total of $16,000. After 4 years, the account is valued at $20,000. You can withdraw up to $16,000 without paying tax or a penalty.
It doesn’t matter how many Roth IRA accounts you have—all your Roth IRAs are treated as one. For example, if you have 2 accounts—one with $18,000 and another with $2,000, you can withdraw up to $16,000 from just one account or from both accounts.
If you convert a traditional IRA to a Roth IRA, the money needs to stay in the account for 5 years beginning with the year in which you made the conversion. For example, if you convert a traditional IRA to a Roth IRA in 2007, you can start making tax-free and penalty-free withdrawals in 2012, regardless of your age.
If you withdraw money before the 5-year test is met, you may have to pay the 10% early-withdrawal penalty. Generally, you pay the 10% early-withdrawal penalty on any amount attributable to the amount that you converted. A separate 5-year period applies to each conversion.
If you’re at least age 59 1/2 at the time you make the withdrawal, you won’t be subject to the 10% early-withdrawal penalty no matter how long the money is in the account. You also won’t pay a penalty if you use the distribution for a first-time home purchase (up to a $10,000 lifetime limit), or you qualify for any of the other exceptions that apply to traditional IRAs.
If the money that you withdraw from a Roth IRA isn’t considered a qualified distribution, part of it may be taxable. By law, there’s a set order in which money comes out of a Roth IRA:
Regular contributions. This money is always tax- and penalty-free.
Conversion contributions. These contributions come out on a first-in-first-out basis. This means that conversions from the earliest year come out first.
Earnings on contributions.
Your earnings are tax-free if you’ve had the Roth IRA for at least 5 years and you’re 59 1/2 or older at the time you withdraw the money.
If you qualify for one of the following exceptions and you’ve had the Roth IRA for at least 5 years, your earnings are tax-free at any age:
The money was used for a first-time home purchase (up to the $10,000 lifetime limit).
The money was withdrawn after you became disabled.
The money was distributed to your heirs after your death. If you die before meeting the 5-year test, the earnings would be taxable to your beneficiaries.
Regardless of your age, your earnings are taxable if you don’t meet the 5-year test even if your earnings are penalty-free. For example, if you use the money that you withdraw from a Roth IRA to pay college expenses, there is no 10% penalty. However, the money will be taxed unless you pass the 5-year test and you’re over 59 1/2.
In addition, there is only one 5-year test for annual contributions. If you open your first Roth IRA in 2007, your 5-year holding period is 2012. If you open a second Roth IRA someplace else with a 2008 contribution, your 5-year holding period for this account is also 2012. However, each traditional IRA that you convert to a Roth IRA has its own 5-year holding period.
The IRS requires your IRA sponsor to send you a Form 5498 showing your annual Roth contributions and any traditional IRA-to-Roth IRA conversions that you made. You should receive the form by the end of May. Make sure you keep these records since the amount of your Roth contributions aren’t reported on your tax return.
When you withdraw money from your Roth IRA, you must report it on Form 8606. This form keeps track of your withdrawals so that you can see if you’ve withdrawn any of your earnings. If you’ve held your Roth IRA for at least 5 years and you’re older than 59 1/2, all withdrawals that you make are tax-free.
Waiting until you’re over 59 1/2 will save you the 10% early-withdrawal penalty but if you deducted your traditional IRA contributions, the money that you withdraw is taxable. If you made nondeductible contributions, however, part of your withdrawal will be tax-free..
You must begin withdrawing money from your traditional IRA by April 1 following the year that you reach age 70 1/2. The IRS will access a 50% penalty if the minimum required amount isn’t withdrawn.
You must make your first mandatory withdrawal by April 1 following the year that you reach 70 1/2:
If your 70th birthday occurs between January and June, you’ll turn age 70 1/2 before the end of that year and you must begin taking your required minimum distribution from your IRA by the following April.
If your 70th birthday is after June 30, your first minimum required distribution would be for the next year and you could wait until April 1 of the following year to take it.
Minimum withdrawals are based on life expectancy and once your minimum required distribution has been determined, you can take the full amount from just one account or from several accounts. For example, if you’re required to withdraw $10,000 a year and you have two accounts, you can withdraw the entire amount from just one account, or you can split the distribution between both accounts.
If you fail to withdraw the minimum required amount, you’ll be subject to a 50% penalty. However, the IRS might waive the penalty if you have a good reason, such as poor health, for not withdrawing the minimum amount.
You can receive distributions from your traditional IRA that are part of a series of substantially equal payments over your life, or over the lives of you and your beneficiary, without having to pay the 10% early-withdrawal penalty, even if you receive these distributions before you’re age 59 1/2. You must use an IRS-approved distribution method and you must take at least one distribution annually for this exception to apply.
In addition, you must continue making these withdrawals for at least 5 years and until you’re at least 59 1/2. If you don’t, you’ll have to pay the 10% early-withdrawal penalty. You may have to pay it even if you modify your method of distribution after you reach age 59 1/2. In that case, the tax applies only to payments distributed before you reach age 59 1/2.
Although this installment method saves you the 10% early-withdrawal penalty, you’ll still have to pay taxes on any amount not considered a return of your nondeductible contributions.
If you’ve held your Roth IRA for at least 5 years and you’re older than 59 1/2, any money that you withdraw from your account will be tax-free. If you open a Roth IRA account after you turn 59 1/2, you still need to wait at least 5 years before you can make tax-free withdrawals of your earnings. You can make tax-free withdrawals of your contributions at any time, though.
Another benefit of a Roth IRA over a traditional IRA is that there is no required minimum distribution. This means that you’re not required to withdraw money after you reach age 70 1/2.
What if the IRA owner dies while there’s still money in the account? Beneficiaries, regardless of the IRA owner’s or beneficiary’s age, don’t have to worry about the 10% early-withdrawal penalty. However, any distribution taken is taxable to the beneficiary, just as it would have been to the IRA owner, even though the funds are inherited.
If you inherit the IRA from your spouse, you can treat the IRA as your own and defer taking the minimum required distribution until age 70 1/2. If you’re not a spouse, you can use the IRS life expectancy tables to determine your distribution over your life expectancy.
Example: Your father died in 2006 and you’re the designated beneficiary of your father’s traditional IRA. You are 53 years old in 2007. According to the IRS tables, your life expectancy in 2007 is 31.4. If the IRA was worth $100,000 at the end of 2006, your required minimum distribution for 2007 is $3,185 ($100,000 / 31.4). If the value of the IRA at the end of 2007 is again $100,000, your required minimum distribution for 2008 would be $3,289 ($100,000 / 30.4). Instead of taking yearly distributions, you can choose to take the entire distribution in 2011 or earlier.
You can elect to take the entire amount by the end of the fifth year following the year of the owner’s death. However, if there’s no designated beneficiary named by September 30 of the year following the year of the IRA owner’s death, the entire distribution must be taken by the end of the fifth year.
Roth IRAs have different guidelines. If you inherit a Roth IRA, the money is tax-free. If you inherit the Roth from your spouse, you can treat it as your own. This means that there are no required withdrawals. However, if you’re not the spouse of the decedent, you must withdraw everything from the Roth IRA within 5 years of the owner’s death or begin withdrawals within 1 year of the owner’s death, based on your life expectancy (the beneficiary’s life expectancy).