What is Early Distribution of a Roth IRA?
There are two primary types of Individual Retirement Accounts (IRAs)--traditional and Roth IRAs. The Internal Revenue Service (IRS) refers to withdrawals from an IRA as "distributions." If you take an early distribution from an IRA, it could be subject to a tax penalty, depending on how you plan on using the money. While Roth IRAs are more tax-friendly than traditional IRAs, you must know the rules if you need premature access to your money.
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Function
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A Roth IRA essentially has an inverse relationship with a traditional IRA. While you can deduct the money you put into a traditional IRA from your taxable income each year, the IRS ends up snagging its share when you take a distribution. Roth IRAs do not offer the same front-end tax benefit. Money invested in a Roth IRA is after-tax income. You can withdraw Roth IRA contributions tax-free at any time, however, regardless of age.
Features
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You benefit by not taking early distributions from your Roth IRA. By parking your money in a Roth--or a traditional IRA, for that matter--until at least age 59 1/2, you enjoy the power of tax-deferred growth. This means that the IRS does not tax your investment earnings annually like they do in a taxable account. Your earnings sit in your account as cash or reinvested in shares of the investment that produced them. Erin Burt of Kiplinger's Personal Finance illustrates the beauty of tax-deferred growth. If you sock $5,000 a year in a Roth IRA starting at age 25, you will end up with about $1.4 million by age 65, assuming an 8 percent annual rate of return. In a taxable account without the tax-deferred growth perk, you would only have about $1 million dollars following the same plan.
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Non-Qualified Early Distribution
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If you anticipate needing IRA money before you turn 59-1/2, a Roth IRA is a no-brainer. As Burt explains, you can access contributions, tax-free, at any time. This makes sense since the IRS already taxed the money you invested in your Roth account as earned income. Prior to age 59 1/2, however, any earnings that accumulated in your Roth IRA that you withdraw are taxed at your regular income tax rate. You must also pay an additional 10 percent tax penalty.
Qualified Early Distribution
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In some cases, you can take an early Roth IRA distribution without paying the 10 percent penalty. According to Burt, you can use up to $10,000 of your Roth IRA money to fund the purchase of your first home. As long as you have held your IRA for five years, the proceeds you use for the house, including earnings, come out tax-and-penalty free. If you have held the account for fewer than five years, you can take the money, but you will pay taxes on any earnings you withdraw. Burt notes, however, that you are still exempt from the 10 percent levy. You can also fund higher education expenses with Roth IRA money. Contributions are tax-and-penalty free. Earnings that you use, however, trigger regular income tax, but not the 10 percent penalty.
Considerations
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As IRS Publication 590 details, unlike a traditional IRA, you are not required to withdraw money from a Roth IRA at any time. If you are relatively certain that you will not need to access your Roth IRA nest egg, early or otherwise, you can conceivably hang on to the account until you die. Of course, you have a choice of who will receive the funds when you pass. Consult your tax advisor to see if a Roth IRA fits into your long-term financial planning.
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