Individual Retirement Accounts (IRAs) can be tricky when it comes to withdrawals and taxes. Their main advantage is that you can enjoy tax-deferred growth within the account – but this can cause confusion when it comes to pulling out your funds.
Simply put, tax-deferred growth means that the account owner does not have to pay any income tax on the capital gains generated within the account. However, these rules only apply so long as the funds remain in the account.
Conversely, the main disadvantage to such retirement accounts is the 10% early withdrawal penalty. An IRA account owner may encounter these penalties for removing funds before they reach 59.5 years of age.
There are two main types of IRAs available to retirement investors: Traditional or Roth accounts. This article will focus on making withdrawals from a Roth IRA, including how it relates to tax time.
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Before we dive into withdrawals, it’s important to understand how contributions work.
When you make a contribution into a Roth IRA, it’s always on an after-tax basis. This means that your funds are subject to taxation before they fund the retirement account.
It’s important to note that you cannot deduct Roth IRA contributions on your tax return. (This benefit is limited to Traditional IRA contributions).
As with traditional IRAs, Roth IRAs have annual contribution limits. Thus, you can only tuck away so much in after-tax dollars per year. The technical term for the total amount of contributions you make into your Roth IRA is a “cost basis” or simply “basis.”
For example, if you contribute $25,000 into your Roth IRA, your cost basis is $25,000.
As an investor, it’s important to keep track of your cost basis, since those dollars have already been taxed. This will come in handy if you withdraw funds from the account prior to age 59.5. (More on that in a minute).
The brokerage provider you use should keep up with the cost basis as well. However, it’s ultimately your responsibility to keep track of this figure.
The unique benefit offered by your Roth IRA is that you can withdrawal all of the funds tax-free, as long as you meet the “qualified withdrawal” requirements.
To meet these requirements, the account must be open and funded for at least five years. You must also be at least 59.5 years old when you make the withdrawal.
For example, if you contribute $50,000 over the lifetime of your Roth IRA, and your balance grows to $100,000 over ten years, you can withdraw the entire account tax-free when you hit 60.
But what if you don’t meet these requirements?
Well, that changes your tax situation.
Because you make contributions into a Roth IRA after-tax, it’s possible to withdraw the funds without a tax penalty.
It’s important to note that when you withdraw funds from a Roth IRA, contributions come out first.
To put some numbers to the concept, let’s assume you contribute $6,000 to your Roth IRA. The account grows to $7,000 due to investment gains.
If you withdraw $6,000 or less from this account, it would not be a taxable event because you have already paid taxes.
This is why it’s so important to keep good records of your retirement accounts. (Especially when tax season rolls around!)
Taxes and penalties may apply when you start dipping into the “earnings” portion of your balance.
Using the previous example, let’s say that you withdraw the full $7,000 at age 50, after funding the account for 10 years.
Remember, when you make a withdrawal from your Roth IRA, contributions come out first, tax-free.
However, that $1,000 in earnings would be subject to the income tax and 10% early withdrawal penalty.
Why?
Because you haven’t paid taxes on those dollars, and the withdrawal is not “qualified.”
Your situation may get a little trickier if you have multiple Roth IRAs. However, the premise is still the same: contributions come out tax-free; earnings prematurely withdrawn do not.
In this instance, your contributions are lumped together, like having one big Roth IRA.
For example, if you contribute $1,000 to one Roth IRA and $3,000 to another, you have a collective cost basis of $4,000 you can withdraw without taxes or penalty.
However, having multiple Roth IRAs means that you’re responsible for keeping track of both accounts. If you want to pull funds out, it’s important to make sure you’re pulling out contribution money – and not your earnings.
As an investor, you should use the retirement accounts that are most suitable for your financial goals. It’s also important to keep in mind your timeline.
Retirement accounts are unique due to their tax-deferred growth. Roth IRAs are even more unusual in your ability to withdraw funds tax-free under the right circumstances.
After all, Uncle Sam doesn’t give the average person a whole lot of tax breaks – so it’s important to leverage them when possible.
Ideally, you’ll never have to withdraw funds from a retirement account prematurely. If you have an emergency savings fund established, you may want to dip into that before your retirement assets.
However, if you know the tax rules, and keep proper records, you may be able to strategically withdraw funds if you are in desperate need of liquidity.
Have questions about withdrawals from Roth IRAs? Let us know!
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