Tax Penalty for Early Distribution of a Roth IRA
There are unavoidable financial emergencies in life. While it isn't ideal to cash in your IRA assets to deal with unforeseen expenses, there are times when you just can't help it. An early distribution from your Roth IRA comes with tax penalties, but those penalties may not be as substantial as you initially think.
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Know the Rules
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The IRS is the regulating body on all IRA accounts. Normal distributions from Roth IRAs must meet two requirements: the IRA owner must be at least 59 1/2 years of age, and the IRA must be in existence for at least five years. Anything not satisfying both requirements is considered an early distribution. Early distributions are subject to both income tax and a 10 percent tax penalty.
What Gets Taxed
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Not every dime cashed out early is taxed when coming from your Roth IRA. The reason is you never got a tax deduction when making the contribution, so your principal in the Roth is after-tax money. After-tax money won't be taxed again, even on early distributions. Only the Roth IRA's earnings are taxed and penalized. For example, if you have $30,000 in a traditional IRA and convert it into a Roth at age 50, then take out all $32,000 two years later, only the $2,000 in earnings is taxable.
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Calculating and Recording Taxable Amount
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Even if you do not meet the requirements for a normal distribution, you might not have to pay taxes; the reason is how the IRS views Roth distributions. The first money put into the Roth is the first money taken out. Since the principal is after-tax money, it doesn't get taxed. Therefore, if you take that same $30,000 IRA that grows to $32,000 and distribute $20,000, you have no taxable event. For the situation where you take all $32,000 out, $2,000 is added to your gross income on Form 1040, and the penalty is recorded by filing Form 5329.
Exceptions
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Certain exceptions apply to Roth IRA early distributions. Exceptions don't pay the 10 percent tax penalty for distributions. Beneficiaries don't pay penalties, nor do Roth IRA owners who become permanently disabled. There is also a first-time home purchase exception and higher education exception. The first-time home purchase exception allows $10,000 to use in buying, building or remodeling your first home. To qualify as a "first-home," the IRS says the IRA owner cannot have owned a primary home for at least two years before the purchase. Unlike the $10,000 limit for the home exception, there is no limit to using a Roth IRA for college tuition, books, fees and boarding.
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