I’ve written about the Roth IRA many times before, with good reason. Hands down, it’s one of the best places to invest for the long-term because it’s one of the only accounts that gives you tax-free money in retirement. But what you may not know is that unlike other types of retirement accounts, you can spend it before retirement without having to pay taxes or an early withdrawal penalty.
Owning a Roth IRA and really understanding all the rules, is another matter. So, in this post, I’ll explain the unique flexibility of these accounts and 4 ways you’re allowed to make penalty-free withdrawals from a Roth IRA to spend before you retire.
Free Resource: Retirement Account Comparison Chart (PDF download) - get this handy, one-page resource to understand the different types of retirement accounts.
In How to Make Kids Rich by Investing in an IRA, I discussed the eligibility rules and benefits of using a Roth IRA to give minors a financial head start in life. A Roth IRA is available to anyone, no matter your age, who has earned income up to certain annual limits (see the article about making kids rich for more details).
With a Roth IRA, your contributions are not tax-deductible, which means you make them on an after-tax basis. Then your investment earnings grow completely tax free—that’s a huge benefit!
Because you pay tax upfront on Roth contributions, you’re allowed to withdraw them at any time for any reason. You don’t owe the IRS additional tax or penalties on that portion of your account. That means you can take out an amount that equals, but doesn’t exceed, the total amount of your original contributions, with no problems.
Because you pay tax upfront on Roth contributions, you’re allowed to withdraw them at any time for any reason.
However, where things get a little confusing is for the earnings portion of your Roth account. The investment growth that your contributions creates is subject to tax in certain situations. There are restrictions on withdrawals of earnings because you haven’t paid tax on them yet.
Also, the IRS says earnings must be distributed from a Roth IRA last. So, how much you want to withdraw and the percentage that would come from earnings determines your potential taxes and penalties.
Let’s say you contributed $5,000 to a Roth IRA every year for 10 years and have a current account balance of $56,000. Your total after-tax contributions add up to $50,000 ($5,000 x 10 years) and your pre-tax earnings total $6,000.
You could withdraw up to $50,000 from the account with no restrictions, tax liability, or penalties. But whether you could do the same with the $6,000 in Roth IRA earnings depends on 3 factors:
1. How long you’ve held or owned the account.
2. Your age.
3. How you plan to spend the earnings you withdraw.
See also: What's the Difference Between a Roth 401k and a Roth IRA?
How Your Holding Period Affects Roth IRA Withdrawals
Roth accounts offer so many great advantages that the IRS wants to make sure you don’t abuse them. The hurdle you must get over before you’re eligible to withdraw earnings tax free is called the Roth 5-year rule.
It’s a waiting period that begins on January 1 of the year your first Roth IRA contribution was made for. It could be different than the actual year you contributed because you have until April 15 to make an IRA contribution for the previous tax year.
Even if you never put another dime into a Roth IRA after your initial contribution, the holding period clock starts ticking and you’ll satisfy the requirement once 5 tax years have passed. And making new contributions doesn’t reset the clock.
Also, if you have multiple Roth IRAs, they’re aggregated together under this rule, which means you get credit for the oldest one. When you satisfy the 5-year rule once, it’s satisfied for good, assuming you keep the account open.
If you don’t meet the 5-year holding period and withdraw earnings from a Roth IRA, they’ll be included in your taxable income for the year. Plus, you may be subject to an early withdrawal penalty, depending on your age.
If you don’t meet the 5-year holding period and withdraw earnings from a Roth IRA, they’ll be included in your taxable income for the year. Plus, you may be subject to an early withdrawal penalty, depending on your age.
See also: Can You Contribute to a 401k and an IRA in the Same Year?
How Your Age Affects Roth IRA Withdrawals
Age is a critical factor when it comes to retirement accounts because they’re designed to encourage you to invest for the long-term. Just about all of them set 59½ as the official retirement age when you’re allowed to begin taking withdrawals. Before that age, taking an early withdrawal comes with a 10% penalty that you must pay in addition to regular income tax.
If you’re over age 59½, you won’t be subject to an early withdrawal penalty for the earnings portion of a Roth IRA; however, if you haven’t owned the account for 5 years, you would have to pay income tax on them. As I previously mentioned, the 5-year rule applies no matter your age.
If you’re under age 59½ and withdraw earnings from a Roth IRA, they will be subject to the 10% early withdrawal penalty—unless you qualify for an exemption, which I cover in a moment. And if you didn’t own the account for 5 years, income tax would also apply.
For example, if you opened a Roth IRA in 2010 and have contributions that total $10,000 and earnings of $1,000, your account is now worth $11,000. If you turned 59½ in 2017, you meet the 5-year holding rule and the age requirement that allows you to make withdrawals of both contributions and earnings with no taxes or penalties.
But let’s say you have the same account, are 40 years old, and want to withdraw the full $11,000, which includes $1,000 of earnings. In that case, you’d have to pay income tax on $1,000. In addition, you’d be subject to the extra 10% early withdrawal penalty—unless you qualify for an exemption.
See also: 7 Simple Principles to Invest Money Wisely No Matter Your Age
4 Penalty-Free Ways to Use a Roth IRA Before Retirement
Assuming you satisfy the 5-year rule, here are 4 ways you can spend Roth IRA earnings penalty-free (but not tax free) before retirement:
1. Higher education expenses.
If you plan to pay for college, that’s one of the best reasons to have a Roth IRA. The tax-free growth is like what you get with a 529 plan, which is a dedicated college savings account.
If you plan to pay for college, that’s one of the best reasons to have a Roth IRA.
However, depending on the 529 plan you choose, the tax benefits could be even better than a Roth IRA because some states offer residents additional incentives. So be sure to do your homework and compare options when paying for college is one of your financial goals.
But unlike a 529 plan, if you don’t end up needing some or all the money for college, you can simply leave it in a Roth IRA and use it for another reason or for retirement.
The education penalty exemption is allowed no matter if you plan to pay expenses for yourself, your spouse, or either of your grandchildren. Allowable, qualified expenses include tuition, fees, books, supplies, and equipment (including computers) required to attend an eligible institution. Plus, if the student attends school at least half-time, room and board qualifies as well.
The funds can be used at just about all accredited private or public schools—such as colleges, universities, and vocational schools—that participate in student aid programs administered by the U.S. Department of Education. If you’re not sure whether a school qualifies, the registrar should know.
See also: A Parent's Dilemma: Save for College or Retirement?
2. Buying a first home.
If you plan to buy, build, or rebuild a first home, you can spend up to $10,000 penalty-free from a Roth IRA. Or a couple who each has a Roth could withdraw a total of $20,000. This is a lifetime limit, so you can only claim this exemption once.
The IRS definition of first-timer homeowner is very broad. Even if you’ve owned a home before, you’re considered a first-timer if neither you nor your spouse have owned a primary residence within the last 2 years. However, if you’re married, your spouse must also be considered a first-timer.
Even if you’ve owned a home before, you’re considered a first-timer if neither you nor your spouse have owned a primary residence within the last 2 years.
You can use this exemption to pay costs associated with buying a primary home for yourself, your spouse, either of your children, either of your grandchildren, or either of your parents or grandparents.
As always, your contributions to a Roth IRA are available to you at any time for any purpose. So, if you have the savings set aside, you could tap that portion of your account for a larger down payment that’s both tax and penalty free.
See also: Buying a Home? Best Ways to Save Your Downpayment
3. Medical expenses.
If you plan to pay for medical expenses for you, your spouse, or your dependents, a certain amount is exempt. You can avoid a Roth IRA penalty on earnings to pay medical costs that exceed 10% of your adjusted gross income, if you haven’t been reimbursed for them by a health insurer, company, or individual.
4. Health insurance.
The last way you can avoid paying a penalty on Roth IRA withdrawals of earnings is health insurance premiums—but only during a period of unemployment. The person out of work could be you, your spouse, or your dependents.
These 4 types of expenses are not the only ways to avoid paying the early withdrawal penalty on Roth IRA earnings. Be sure to see IRS Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs) for more information.
See also: The Rules for Using a Spousal IRA
What If You Have No Plans for Spending Funds in a Roth IRA?
You know you should be saving for retirement. There comes a time when every one of us will need to stop working due to physical or mental limitations—or when we choose to transition to a lower paying career or to quit altogether.
But even if you have no idea how you’ll spend money that you squirrel away, the beauty of putting it into a Roth IRA is that it’s not completely locked away. There’s so much flexibility and great tax breaks that there’s very little downside to using these great accounts.
See also: 5 Retirement Account Options When You're Self-Employed
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