What Is the Tax Penalty for Cashing in Your Roth IRA Early?
Roth IRAs are retirement savings account that many people turn to. One of the benefits of a Roth IRA is the tax-free income it provides after age 59 1/2. Even the best planning can't always calculate tor unexpected financial hardships. While you can cash in your IRA early if suck a circumstance occurs, there are potential tax penalties to consider.
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Roth IRA Rules
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Contributions made into a Roth IRA receive no immediate tax benefit, meaning the contributions do not reduce your annual income like traditional IRA contributions do. Once the Roth IRA is established, you must hold it for at least five years and until age 59 1/2; both of the regulations must be met to cash out tax-free. Establishment of the IRA refers to the day the account is funded either by your first contribution or by a Roth conversion -- taking an existing traditional IRA and converting it into a Roth, paying taxes on the balance.
Cashing Out
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The IRS can't force you to keep the money in the account; the IRS can only encourage you to do so by imposing penalties for early distribution. Early distributions are any funds taken out of the IRA before you meet both the five-year and 59 1/2-year rules. Since the contributions in the IRA are after-tax dollars, you are not required to add the principal amount to income taxes. The earnings, however, are added to gross income and penalized 10 percent by the IRS.
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Recording Early Distributions
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You will receive a 1099-R from the IRA custodian when you take a distribution. The taxable portion is listed on the 1099-R and added to line 15 when you file your personal tax return, Form 1040. You must also complete Form 5329 to record the penalties. To your benefit, the IRS looks at Roth distributions based on the FIFO (first in, first out) method of accounting. This means your contributions are the first distributions. If you take out less than you contributed, only after-tax dollars are recorded and you have no taxable event. For example, if you have $20,000 in contributed Roth IRA funds and take out $3,000 in the fourth year, there is no taxable distribution. If your IRA grows to $25,000 and you cash out the entire amount, $5,000 is taxable.
Early Distribution Exceptions
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There are situations where no penalty is applied, even if the entire amount is distributed. If you become permanently disabled, there is no penalty for distributions. Beneficiaries pay no penalties if you die before 59 1/2. You can also use $10,000 of your Roth IRA to buy or build a first home for you, a child or grandchild. You may also pay college expenses for yourself, spouse, child or grandchild without penalty.
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