Penalty for Cashing in a Roth IRA

Early Roth IRA withdrawals need careful figuring to avoid penalties.

Roth individual retirement accounts, or Roth IRAs, allow people of modest means to accumulate a large sum of money tax free for their retirement. If you meet the qualifications, you can cash in your Roth IRA without paying any taxes or penalties. The interest or capital gains earned while your money was in the Roth IRA aren't taxed. But you may face substantial penalties if you cash in a Roth IRA open for less than six years or if you are younger than age 59 ½.

Qualified Distributions

A qualified distribution is one you take after you turn age 59 ½ from a Roth IRA account open for six or more years. You will owe no taxes on that distribution. According to the investment advisers at The Motley Fool, other distributions are non-qualified, unless you meet certain exemptions. If you make a non-qualified withdrawal that's not covered by an exemption, you will pay income tax plus a 10 percent penalty on the amount attributed to earnings from the Roth IRA.

Typical Penalty Example

For example, take a $30,000 Roth IRA account consisting of $20,000 in your contributions and $10,000 in earnings, opened six or more years ago. If you close out that account before age 59 ½, you won't owe anything on the $20,000 that you contributed because you already paid the taxes on that money. But the $10,000 in earnings will be added to your taxable income for that year and taxed at your marginal rate. You will also owe a 10 percent penalty on the $10,000 in earnings, or $1,000.

Another Account Penalty

Even if you are over age 59 ½, you might still incur taxes and penalties if you close out a Roth IRA account open for less than six years. In such cases, you will have to pay a 10 percent penalty plus income taxes on the IRA's earnings despite your age.

Penalty Exemptions

You can avoid tax and penalties for early close-out of your Roth IRA account if your action falls under certain exempt situations, said The Motley Fool's experts. Early withdrawals are exempt from taxes and penalties if the Roth IRA owner becomes disabled. Other exempt situations are if the owner dies and the Roth IRA money goes to his heirs. Early withdrawals that are a series of annuity-like equal payments over the Roth IRA owner's expected lifetime also are exempt. Other exempt early-withdrawal situations are to pay college tuition, medical expenses exceeding 7.5 percent of income, health insurance premiums if you're unemployed, up to $10,000 to make a down payment on your first house, or to cover taxes levied by the IRS on your IRA.

Partial Withdrawals

If you make early withdrawals that only partially drain your Roth IRA, there are additional complications, said The Motley Fool's financial experts. The Internal Revenue Service attributes partial withdrawals first to your original contributions and then to your Roth IRA earnings. If you had a $30,000 Roth IRA with $20,000 in contributions and $10,000 in earnings that was open for six years or more, and you were under age 59 ½, you can take out up to $20,000 in the same year without paying tax or a penalty because you already paid the taxes on that money. Of course, you'd no longer earn any return on the withdrawn amount.

Things Get More Complex

But if you were under age 59 ½ and withdrew more than your $20,000 original contribution from this example account in the same year, then the Internal Revenue Service would pro-rate the withdrawal. The IRS would assume two-thirds of the withdrawn amount was from contributions and one-third from earnings. So you would owe tax and a 10 percent penalty on one-third of your withdrawal. The Motley Fool suggests you not take an early withdrawal from a Roth IRA that exceeds your original contributions unless you fall into one of the exempt situations.

References

• The Motley Fool: Roth IRA Withdrawal Penalties