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Reviewing rules for taking money out of a Roth IRA

 

By Randy Neumann

The rules for withdrawing money from a Roth Individual Retirement Account are different than they are for a traditional IRA; therefore, let’s begin with a description and comparison of each.
The traditional IRA was created by the first federal pension law – the Employee Retirement Income Security Act a.k.a. ERISA – in 1974.  This was a good piece of legislation because, in addition to creating the IRA, it stopped companies from stiffing former employees by moving to another state and ceasing pension payments.  Prior to the law, employers could escape pension liabilities by crossing state lines just like the fabled bank robbers Bonnie and Clyde.
The Roth IRA, which was created by the Taxpayer Relief Act of 1997 (don’t you love these names?), was named for its advocate Sen. William Roth of Delaware.  Roth may have been a good legislator, but he was an angry loser.  When his constituent, Dave Tiberi, lost a split decision to middleweight champion James Toney in Atlantic City in 1992, Roth launched a federal investigation into the sport of boxing in New Jersey.  Anyway, here is how a Roth differs from a traditional IRA.
In a traditional IRA, you get an income tax deduction on your contribution, the money grows tax deferred until you take it out, at which time you pay tax on the amount withdrawn. With a Roth, you do not get an income tax deduction on your contribution; however, if you leave the money in the plan for five years and take it out after age 591/2, you do not pay tax on any gains in the plan.  Some other pros and cons of the two IRAs are as follows.
You can roll other qualified plans into a traditional IRA; for example, at retirement, you can roll over your company 401(k), profit sharing, etc., into a traditional IRA without any tax consequences.  You cannot “roll over” these plans into a Roth IRA.  For wealthy people, a traditional IRA is not such a wonderful asset to own because the income, inheritance and estate tax (assuming Congress addresses the estate tax) can consume 88 cents of every dollar in an IRA before an heir receives it.  However, there is a new quirk in the law that allows taxpayers to convert traditional IRAs to Roth IRAs regardless of income.  The only problem is you’ve got to pay the tax now.
Sometimes people want to access Roth IRA funds for early retirement or other purposes.  Maybe you are one of them?  You can withdraw regular contributions tax-free, but not your earnings.  This is a critical distinction that many Roth IRA owners don’t seem to know about.  When you withdraw assets from a Roth, there is a set order in which contributions and earnings must be distributed.
The IRS regards the first layer of withdrawals from a Roth as regular contributions instead of earnings, thus this layer is treated as coming from your annual after-tax contributions.  When withdrawing this layer of money, there are no taxes or penalties involved.  (You can do this at any time, whether you have held your Roth for five years or not.)  Basically, the IRS is permitting you to remove a percentage of your account before the alarm sounds on the five-year clock.
The next assets to be removed from the account, according to IRS rules, are the conversion and rollover contributions to your Roth.  These are removed on a so-called “first in, first out” basis. Contributions to your Roth resulting from a conversion in 2002 would have to be withdrawn before those made in 2008.  The taxable portion of the conversion/rollover contribution comes out first (the amount claimed as income), and then the nontaxable portion.
Lastly, earnings accrued by the Roth IRA are distributed; in other words, merely withdrawing your regular contribution will not trigger a tax.  But if your Roth has realized earnings from contributions, the earnings will be subject to income tax if they are withdrawn.
Is your withdrawal a qualified distribution?  If so, take this into consideration:  If you have owned your Roth IRA for less than five years and/or are younger than age 591/2, you risk taking a nonqualified distribution if you withdraw money from it.  You know what that means, right?  You will incur a 10% penalty for early withdrawal in addition to taxes.  There are some exceptions to this outlined in IRS Publication 590.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for the individual.  Randy Neumann CFP® is a registered representative with securities and insurance offered through LPL Financial.  Member FINRA/SIPC.  He can be reached at 12 Route 17N, Suite 115, Paramus, 201-291-9000.

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