I have spoken about Roth IRA before and its benefits. It is an amazing offering that allows one to park money for tax-free growth but doesn’t truly lock it away. The withdrawal of income is a handy safety net that allows access to cash for emergency needs but allowing it to stay tax-sheltered as long as it is not withdrawal. It is one of the strongest tools in hands of individuals seeking FIRE.
The rules for Roth IRA withdrawals can be a bit tricky for some situations. Here is the summary for Roth IRA (and Roth 401K) withdrawal rules.
Rules for Direct Deposits
For the money that is invested directly in a Roth IRA, the contributions can be withdrawn at any time for any reason. There is no tax or penalty for withdrawal of contribution. The growth can be withdrawn without penalty only if you are more than 59 1/2 years old and the account is open for more than 5 years.
|Age at which Roth IRA was open.||Age to withdraw Contribution without penalty||age to withdraw growth without penalty|
The key thing to remember is that the 5-year start from the 1st of Jan of the year for which deposit was done. i.e. if you deposit $ 5,000 on 1st of April 2018 for the year 2017, your Roth IRA is deemed started on 1st Jan 2017 and completes 5 years on 1st of Jan 2022.
Also, you can withdraw all of the amounts after 5 years irrespective of when it was deposited as long as you are more than 59.5.
Ther are some other scenarios where money can be withdrawn from Roth IRA without penalty. As long as an IRA plan participant meets the five-year rule requirement (meaning it’s both tax- and penalty-free), any withdrawal is considered qualified by the IRS if any one of the below conditions is met.
- The person is over 59½
- Death or disability
- Qualified first-time home purchase (up to 10K)
There are some other situations where money can be withdrawn from Roth IRA without triggering the penalty. These are:
- The distributions are done as a part of a series of substantially equal payments (five years or until the Roth IRA owner reaches age 59½, whichever is longer).
- payment of unreimbursed medical expenses exceeding 10% of your Adjusted Gross Income (AGI).
- For paying medical insurance premiums after losing your job.
- The distributions are for qualified higher education expenses (for yourself, spouse, children, or grandchildren)
There is only one Roth IRA clock, even if you have multiple Roth accounts at different providers. This clock doesn’t apply to Roth 401K though.
Rules for Conversions
Withdrawal rules for IRA or 401K to Roth conversions behave slightly differently. The conversion has a 5-year waiting rule implying that for each conversion, the amount can be withdrawn after 5 years. Again, the date is taken as 1st of Jan from the year it was deposited. e.g. anything deposited in 2018 would be considered as 1st Jan 2018.
Unlike the 5-year rule for contributions, where all 5 years of contributions can be withdrawn at end of 5 years, in the case of conversions, each conversion amount has its own unique 5-year time period.
When withdrawal occurs from a Roth IRA, it goes in FIFO order and oldest conversions are considered to be withdrawn first. The order goes for withdrawals go as:
This allows a person to withdraw traditional IRA amounts without a penalty before reaching 59 1/2. Look at the following scenario.
Grady is 40 years old and has 500,000 in his IRA. Grady decides to retire early and relocate to a different country and wants to withdraw from his IRA. if he withdraws it directly, he would pay taxes and a 10% penalty. If he converts it to Roth IRA, he only pays taxes on the conversion. At 45, Grady can withdraw 500K from his Roth IRA without the penalty though he cannot withdraw the growth on 500K without penalty.
Roth 401K Withdrawal Rules
Roth 401K follows the same rules as a Roth IRA. The waiting time is the same (5 Years) and so are the qualified distribution conditions.
In case of a conversion from a Roth 401K to Roth IRA though, Roth 401K years are not counted for Roth IRA. Hence, at the time of conversion, the Roth IRA clock starts from the beginning.