When it comes to yoga, marriage and retirement investing, one thing is key: flexibility. And a Roth IRA is, without a doubt, the most limber of your retirement-savings options, including the ability to take early withdrawals without penalty. Early withdrawals generally mean you’re taking the money out before you reach age 59½ or meet other specified conditions you’ll read about below.
Generally speaking, it’s best to leave your retirement account untouched so that you can maximize your returns. But for unforeseen expenses, it can be a lifesaver. And, if you’re planning to buy your first house, a Roth can be a great part of a disciplined plan to save for the down-payment. That’s because a Roth allows for early withdrawals—income tax- and penalty-free—for specified financial needs such as supporting yourself after a disability or buying a first home.
Contributions vs. Earnings
First a short detour into regulatory jargon. To know what withdrawing money early is going to cost you, you need to know the difference between contributions and earnings.
Contributions are the funds that you deposit into your Roth IRA. Because your contributions are always made with after-tax dollars (you already paid income tax on that money), you can withdraw your contributions before retirement without having to fork over cash for taxes or penalties.
Withdrawing your earnings is a different matter. Any money in a withdrawal that exceeds the amount of your original contributions is considered “earnings” and is subject to possible penalties and taxes. The penalty for early withdrawal of earnings, except under certain specified conditions, is 10 percent of the earnings that you withdrew. In addition, you may have to pay income taxes on those withdrawals.
Income-tax and Penalty Free
To withdraw earnings without paying taxes or penalties, you must follow very specific rules. The first requirement is that the withdrawal must be taken five years or more after the account was opened. The IRS counts the five years from the first day of the tax year in which you make your first Roth contribution. In other words, if you open the account on Nov. 1, 2017, the IRS actually starts the clock at the beginning of the tax year, that is, Jan. 1, 2017 (when the IRS gives you a gift like that, you take it).
If you satisfy the time requirement, the IRS says distributions qualify to be both income-tax and penalty free if:
- the money is used to buy, build or rebuild a first home, up to a $10,000 maximum that is spent within 120 days of the withdrawal
- the money is withdrawn because you suffered a disability
- the money is distributed to your beneficiaries or to your estate after you die
When a withdrawal fits these requirements, it is called a “qualified distribution.”
Certain other withdrawals still require you to pay income tax, but the IRS won’t punish you with an additional 10 percent early withdrawal penalty. The most common is for higher education expenses. You don’t have to pay the penalty if the withdrawal is for less than or equal to the amount you pay that year for tuition, books, room and board, etc. Some kinds of unreimbursed medical expenses also qualify. Click here for the list of early withdrawals that qualify, according to the IRS.