Financial Resource Center

Retirement Planning

Roth IRA Early Withdrawals May Prompt Penalties

by Darla Dernovsek / January 22nd, 2007

Like chocolate woos a dieter even when it's stored in a drawer, money in a Roth IRA (individual retirement account) can tempt accountholders who need funds in a hurry. And just as dieters often come to regret that sweet treat the next time they get on the scale, accountholders who make early Roth IRA withdrawals can find themselves wishing they'd sought other sources of funds at tax time or, equally important, when they're ready to retire.

Understanding Roth rules

Adults meeting income guidelines are eligible to make after-tax, nondeductible contributions to their Roth IRAs. The Roth's major advantage is that earnings on the account are tax-free, as are any withdrawals, as long as two conditions are met:
  • The accountholder is at least age 59 ˝ or meets specific conditions set by the Internal Revenue Service (IRS), known as "exceptions."
  • The funds being withdrawn have been in the account for at least five years.
Withdrawals that meet those conditions are called "qualified distributions." When accountholders make withdrawals that fail to qualify, they face a 10% early withdrawal penalty. In addition, they must pay taxes on any withdrawn earnings, based on their standard income tax rate. Even qualified withdrawals can eat into retirement funds in a hurry, according to two retirement planning experts: Becky Nilsen, CEO of Desert Schools Financial Services LLC, a wholly owned subsidiary of Desert Schools Federal Credit Union, Phoenix; and Steve Franke, program manager for CUSO Financial Services, L.P., a broker-dealer serving members at Pennsylvania State Employees Credit Union, Harrisburg, Penn.
Withdrawals that fail to qualify face a 10% early withdrawal penalty.
Unqualified withdrawals do even more damage because of the higher cost of taxes and penalties. That's why both Nilsen and Franke advise accountholders to think carefully before tapping into a Roth IRA. "This really should be your very last alternative," Nilsen says.

Examining exceptions

IRS rules create exceptions that allow Roth IRA accountholders younger than age 59 ˝ to withdraw the principal without facing tax penalties. Tax penalties still will apply, however, on any earnings that are withdrawn. To qualify as an exception, funds being withdrawn must have been in the account for at least five years, measured from the beginning of the tax year when the funds were deposited. In addition, the accountholder also must meet IRS standards for one of these conditions:
  • You're using the distribution to pay certain types of first-time home-buying expenses.
  • You are disabled.
  • You have significant, unreimbursed medical expenses.
    Roth IRA withdrawals should be "your very last alternative."
  • You're paying medical insurance premiums after losing your job.
  • You're using the distribution to pay qualified higher education expenses, as long as the distribution is not more than the expenses.
  • You suffered an economic loss as a result of Hurricanes Katrina, Wilma, or Rita.
  • The accountholder dies and you are the beneficiary.
A distribution also may be an exception if part of a series of substantially equal payments, or if they are the result of an IRS (Internal Revenue Service) levy on the plan. IRS rules about what qualifies for an exception are online in IRS Publication 590, Individual Retirement Arrangements, that offers step-by-step guidelines. To be safe, Nilsen advises accountholders to consult a qualified tax adviser any time they intend to take a withdrawal if they are younger than age 59 ˝.

Adding it up

When withdrawals are not "qualified," or fail to meet the standards for exceptions, the costs can be high. Consider the example of an accountholder in the 33% tax bracket who takes $1,000 out of his earnings in a Roth IRA even though his deposit has been in the account less than five years. The accountholder must pay the 10% penalty of $100, plus $330 in income taxes, for a total of $430.
Accountholders can make withdrawals in certain circumstances without facing tax penalties.
Even when withdrawals are exempt from taxes and penalties, Franke points out that accountholders may face other costs. For example, early withdrawals from Roth IRAs held in share certificates of deposit (CDs) may prompt "loss of interest" penalties for the most recent quarter. If the IRA is held in a mutual fund or annuity, withdrawals could trigger surrender fees. Franke says many members choose to invest Roth IRA funds in accounts designed to maximize their return over time, such as mutual funds linked to the stock market. These mutual funds will fluctuate with the market--they go up and down in value--but typically provide returns greater than inflation to help grow retirement savings. Withdrawing money from this type of mutual fund during a market downturn could significantly reduce overall earnings. In addition, any withdrawal will undermine the member's ability to use compound interest to boost retirement savings. "You can subject yourself to a lot of negatives by trying to withdraw the money early," Franke notes.

Exploring options

One way to weigh the value of a Roth IRA withdrawal is to consider if the long-term benefits of having the cash now outweigh the long-term benefits of leaving the funds in the account.
When withdrawals are not "qualified," your costs can be high.
An example that meets this standard might be a young mother returning to college after a divorce to obtain a degree to support herself and her family. She may choose to withdraw money from the Roth IRA to meet her qualified higher education expenses. "In that example, it makes sense to tap into the Roth account because she's going to help increase her wage earning capability, so she can replace that money after she graduates," Nilsen says. Those situations are rare, according to Franke and Nilsen, who advise accountholders to consider a credit union loan instead of making a Roth IRA withdrawal. Better yet, Franke advises accountholders to create a savings account for emergencies. Gradually increase the amount in the account until it covers three to six months of living expenses, even if it means you must delay deposits to retirement savings. Over time, the emergency fund will protect retirement savings by giving you another option to pay for urgent, unexpected expenses.

Waiting for retirement

"It's much easier if people just get it in their heads that we put retirement money away and we aren't going to withdraw it until after age 59 ˝," Franke says. Once you pass age 59 ˝, Nilsen says it's still important to make careful decisions about withdrawals as part of a retirement income financial plan. This plan maps out withdrawals from all sources of income to create a systematic approach to replacing wages after retirement. Just as you plan ahead to make deposits to a Roth IRA, planning ahead to withdraw Roth IRA funds is the best way to make sure you have money when you need it.
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