What Happens When Cashing a Roth IRA?

A Roth Individual Retirement Account (IRA) is a retirement plan that confers some significant tax advantages. You do not get a tax deduction for contributions to a Roth IRA. However, if you cash in a Roth IRA in accordance with IRS rules after you reach retirement age or for certain other reasons, earnings are not subject to federal or state income taxes.

Retirement

Under normal circumstances you are supposed to leave funds in a Roth IRA until two conditions are met. You must be 59 1/2 years of age. In addition the Roth IRA has to be open for at least five calendar years--including the entire tax year in which the account was set up. If you roll over or convert funds from another type of retirement plan, those funds must remain in the Roth IRA for at least five years. However, when you cash in the Roth IRA with these conditions fulfilled, you pay no income taxes on investment earnings.

Contributions

You may cash in money you contributed to the Roth IRA at any time without any tax liability. Contributions are not tax-deductible so there is never any tax liability. If you do withdraw money early, the IRS considers it contributed funds unless you exceed the total amount you have contributed up to the time of the withdrawal. You are required to document the withdrawal by completing and attaching IRS Form 8606 (Nondeductible IRAs) to your income tax return. If you withdraw more than you have contributed for any reason you also have to file Form 5329 (Additional Taxes on Qualified Plans).

College And Home

You can cash in a Roth IRA early and the money will still be exempt from state and federal income taxes if the money is used to pay qualified higher education (college) expenses such as tuition. The same holds true if you use the money for the purchase or repair of a first home, although there is a $10,000 lifetime limit.

Exceptions

The IRS does allow you to cash in Roth IRA funds early without penalty for some hardship situations. These include medical expenses not covered by insurance if they exceed 7.5 percent of your annual income, to pay for health insurance while unemployed or if you become disabled. You still have to pay federal and state income taxes on the money, but the IRS won’t assess any penalties.

Penalties

If you cash in a Roth IRA early and the money is not used for a qualified purpose, you will have to pay a penalty tax of 10 percent of the amount improperly withdrawn. The penalty is on top of federal and state income taxes on the money withdrawn.

References

• IRS Publication 590: Roth IRAs
• Fairmark: Roth IRA Rules of Thumb
• Fairmark: Distributions from Roth IRAs