Money Matters

Tapping IRAs early raises issues over taxes and penalties

October 27, 2012 

Q: I am in need of money and want to tap my Roth IRAs. I have both a contributory Roth IRA which I began three years ago and a conversion Roth I established four years ago. The conversion has more money, but I’m thinking that I should cash in the contributory first since it has very little gain and I think I can take out all contributions without tax consequences and since I am over 59 1/2 gains are also tax free. It’s my understanding that there would be tax consequences if I withdraw from the conversion Roth since it is less than five years since the conversion. A refresher on Roth IRA withdrawal rules would be appreciated!

A: These are confusing topics; I say that in the plural because the rules are slightly different for contributory Roth IRAs and conversion Roth IRAs. Let’s take them one at a time.

Contributions to a Contributory Roth IRA can be taken out at any time without taxes or penalties. There is no age or five-year rule to meet. You can be under or over age 59 1/2 , and if for any reason you change your mind, even the very next day, your contribution can be taken out. If the value has declined due to the market, you will have access to less money than you contributed and if the market has increased you will not face taxes or any penalties if you limit your withdrawal to the amount contributed.

Earnings are a different matter. Withdrawals of earnings need to meet some other tests to determine if they are tax and/or penalty free. These tests are: qualifying reasons for a distribution; other exceptions and the five-year rule.

Start with: Is there a qualifying reason for the distribution/withdrawal? Qualifying reasons are: having reached age 59 1/2; distribution made to a beneficiary after the Roth IRA owner’s death; you are disabled or the distribution is used to pay certain qualified first-time homebuyer expenses. If you can answer “yes”, you then answer the five-year rule question.

Earnings distributed prior to the fifth year after your first Roth IRA was established do not meet the five-year rule. Example: A Roth IRA opened anytime in 2009 will not meet the five-year rule test until Jan. 1, 2014. Once you meet the five-year rule test for one Roth IRA, you meet this test for all subsequent contributions. If you can answer “yes” to both the qualifying reason and the five-year rule question, earnings may be withdrawn tax and penalty free. If you can answer “yes” to the qualifying reason question but answer “no” to the five-year rule you will owe taxes on the earnings but not pay a penalty.

If the answer to the qualifying question is no then you move on to the “do you meet one of the other exceptions” question. A “yes” answer will avoid the 10 percent penalty, but income taxes will still be owed. A “no” answer will cause the distribution to be taxed as ordinary income and be subject to the 10 percent penalty. Other exceptions are: you have unreimbursed medical expenses exceeding 7.5 percent of your adjusted gross income; you are paying medical premiums after losing a job; the distribution is due to an IRS levy on the account; you are a qualified reservist; it is for qualified disaster recovery assistance; it is a qualified recovery assistance distribution, or it is used for qualifying higher education expenses.

Converted amounts from a traditional IRA to a Roth IRA will be subject to the 10 percent penalty but not ordinary income taxes if they are distributed prior to the first day of the fifth year after the date of the conversion – unless – the distribution was for a “qualifying reason” or you meet one of the “other exceptions” as listed above.

Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 99466, Raleigh, NC 27624

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