There are several retirement accounts that the federal government provides tax breaks for, but as far as withdrawals go there are just two account types:
- A Traditional IRA or another account like it, such as a 401k or SEP, that allows you to put earnings into that account before paying taxes on them
- A Roth IRA that requires that you pay taxes on your account contribution when you make it.
Although you may withdraw as much as you like from either of these account types at any time, with a few exceptions there are penalties for early withdrawals. With one exception, you are also required to pay income taxes on the money withdrawn.
However, because the capital contribution to the Roth is post-tax, that portion of the funds in your Roth can be withdrawn at any time without penalty. Penalties and interest on early withdrawals from Roth accounts get complicated quickly, because often any early withdrawal will involve both your capital contributions and taxable and penalty-eligible earnings on those contributions.
You can withdraw funds from both types of IRAs without penalty when you reach age 59 1/2. The IRS also offers a small group of exemptions that allow you to take out funds early from either account type:
- Qualified education expenses for yourself, your spouse, your child or your spouse's child, including adopted and foster children and their descendants.
- First-time house buyers may qualify for up to $10,000 penalty-free withdrawal from either account type to make a down payment. If you intend to exercise this right, read the IRS document covering these requirements.
- Medical issues may qualify for penalty-free early withdrawals. These include: total and permanent disability, payments on health insurance during unemployment and unreimbursed medical expenses. The IRS provides more details about acceptable expenses.
In the absence of one of these exceptions, early withdrawals from retirement plans other than Roth IRAs incur the 10 percent penalty on all funds withdrawn. Since you've already paid taxes on Roth contributions, you can withdraw the capital contribution portion from a Roth at any time. The catch is that you have to document that the amount withdrawn early is capital, not earnings on that capital, which is both taxable and eligible for the early withdrawal penalty. This requires reconstructing the information from the 5498 forms your IRA custodian sends every year you make a Roth IRA contribution. For most taxpayers, the safest way to do this is to hand the task over to the IRA custodian, if the custodian is willing to compute it. Alternatively, obtain the 5498 records from the custodian and bring them to your tax advisor.
The IRS also allows penalty-free early withdrawals from Roth IRAs if the amounts withdrawn are periodic and equal. This is a sufficiently complex subject that most IRA custodians -- Schwab, for example -- won't make the calculation and advise you to consult your tax advisor.
Withdrawals in Retirement
Although other retirement plans require that you pay taxes on withdrawals in retirement, if you have at least one Roth IRA open for five years, you can withdraw funds without a tax payment of any kind. The five-year period begins on January 1 of the tax year in which you make your first Roth contribution.
Roth IRAs enjoy another advantage over other retirement accounts. With a Roth IRA you keep your funds in the account for as long as you like. Other accounts must begin annual required minimum withdrawals at age 70 1/2. The amount of the RMD, which is calculated by dividing the account balance as of December 31 of the prior tax year by the applicable distribution period based on your life expectancy, is another IRS-required calculations you may want to turn over to your tax advisor.