Roth IRAs Can Be More Flexible Than Other Retirement Accounts
A Roth IRA comes with some unique benefits not available to other types of retirement accounts.
We recommend prioritizing retirement savings and especially a Roth IRA, even when you think you cannot afford it. Due to a little known rule, in many circumstances you can withdraw the funds that you contributed to the Roth IRA without penalty.
A Roth IRA is not available to everyone, but it is available to many. If you are not sure if you are eligible, check the guidelines at the IRS website.1 Take note, if you are 50 or over, there are “catch-up” provisions, so you can contribute even more to your Roth IRA.
The IRS penalizes individuals who make withdrawals prior to age 59 ½ from qualified retirement accounts such as a traditional IRA or 401k plan. Non-exempt withdrawals before 59 ½ are subject to a 10% penalty, plus ordinary income taxes on the withdrawal.
Withdrawal exemptions
But for Roth IRA accounts, you can always withdraw the amount you contributed. This exemption can be taken at any time and for any reason.
For example, if you contributed $5,000 each year for ten years into your Roth account, you would be allowed to withdraw the $50,000 you contributed without tax or penalty. Any growth attributed to those contributions would remain in the account.
Prior to 59 ½, only direct contributions are exempt in this manner – growth and conversion amounts do not qualify. After 59 ½, all withdrawals are exempt from penalty and tax, if you have met the five-year rule.
If you want to withdraw more than just the amount you contributed and avoid paying a 10% penalty, you may withdraw funds if you have a qualifying circumstance and satisfy the five-year rule.
The most common qualifying circumstance allows you to withdraw up to $10,000 for a first home purchase. This amount is above and beyond your contribution amount. In our example, this means withdrawing $60,000 ($50,000 of contributions and $10,000 of first home purchase qualifying expense) is allowed tax-free.
The five-year rule states that the year you withdraw has to be at least five tax years since your first contribution to the account in order to avoid paying tax.
Start the clock now
The five-year rule is a good reason to open and contribute to a Roth IRA as soon as possible even if it is a small account. Starting the five year clock as soon as possible will maximize your account’s future flexibility and once you have one Roth IRA for five tax years, the requirement is satisfied for all of your Roth IRAs.
If you have satisfied the five-year rule and do not have a qualifying circumstance though, you are subject to both the 10% penalty (if under 59 ½) and regular tax on the account’s earnings if you withdraw more than your contributions.
There are a few other exceptions which allow you to withdraw the growth from your Roth IRA even though there may not be qualified reasons for a distribution. These exceptions avoid the 10% penalty but do not avoid owing ordinary income tax on the growth; these include:
- education expenses for you, your spouse, a child, or a grandchild (sometimes more attractive than a 529 plan)
- medical expenses in excess of 7.5% of your adjusted gross income
- paying medical insurance after losing your job
- an IRS levy of a qualified plan
- for military personnel: a qualified reservist distribution during active duty.
Just because you can avoid the 10% penalty does not mean you should withdraw money from your Roth account without good cause. Once you withdraw from a Roth IRA, you may not be able to return that money to the account as a prior year’s contribution. However, you could still contribute for the current tax year, if you meet the income limits.
The intention of tax-advantaged retirement accounts is for long term savings. IRS rules discourage frivolous early withdrawals. Contributing to your Roth IRA is possibly an excellent place to store savings so long as you have had a Roth IRA account for at least five tax years or you are willing to wait.
If your options to fund retirement accounts are limited, we’ll want to talk about prioritizing contributions to a Roth IRA. With a Roth IRA’s flexibility, you may have access to the account’s funds if you need it, and if you don’t need the money, it will remain in an environment where it will grow tax free.
Contributing to a Roth IRA should be one of your top priorities, even if the money you are contributing is earmarked for a different purpose later. For many of us, it may be a smart decision to include a Roth IRA.
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