When it comes to saving for retirement, there are a multitude of options available to help you do just that. One of the more popular options people choose is an IRA, also known as Individual Retirement Account. The two main IRAs are Traditional and Roth IRAs and they can be used as alternatives to the traditional 401K.
An IRA is an investment account that allows workers to invest their earned income to encourage them to set aside money (earnings) for retirement. Unlike the traditional IRA, Roth IRAs are non tax-deductible which means you do not have to pay taxes when you qualify for your withdrawal. For this reason, Roth IRAs have become very popular.
If you decide to apply for a Roth IRA, it’s extremely important to be aware of the general rules and penalties associated when managing your account. Check out these simple rules and regulations associated with Roth IRAs.
Roth IRA vs Traditional IRA
Like we mentioned before, an IRA is an investment account that is designed to encourage workers to invest in retirement. With both Traditional and Roth IRAs, your contribution limit generally is the lesser of:
- $6,000 ($7,000 if you are age 50 or older), or
- Your taxable compensation.
Both options also allow you to invest in a variety of different investments such as stocks, bonds, mutual funds, annuities, exchange traded funds (ETFs), index funds, and so on.
|ROTH IRA||TRADITIONAL IRA|
|Contributions made with after-tax dollars.||Contributions made may be tax-deductible.|
|Your earnings grow tax-free.||Your earnings grow tax-deferred.|
|You don’t pay income tax on distributions.||You pay income tax on distributions.|
|Contribution limit based on filing status and income thresholds.||Contribution limit is not based on income thresholds.|
So what’s the difference between a Roth IRA and a Traditional IRA? The primary difference between the two is the way they are taxed. With a Traditional IRA, the amount you can contribute annually (up to $6,000) can be deducted from your taxable income which reduces the amount of income tax you’ll owe for the year–providing immediate benefits. However, when you withdraw your money in retirement, you will be taxed on those withdrawals.
On the other hand, contributions to a Roth IRA are non-tax deductible, but qualified withdrawals are tax and penalty free. Roth IRAs also offer flexibility with non-taxable withdrawals compared to a 401K. With that being said, Traditional IRAs are best if you think your tax bracket will be lower by retirement and Roth IRAs are better if you anticipate taxes to be higher when you retire.
When Can I Withdraw From My Roth IRA?
The contributions you make with a Roth IRA are not tax-deductible, but earnings can grow tax-free. Roth IRA withdrawal rules vary depending on your age and how long you’ve had the account. You can withdraw from your Roth IRA at any time, but before you make a withdrawal, keep in mind these guidelines so you can avoid the potential 10% early withdrawal penalty:
- You must be the age of 59 ½ or older to make a withdrawal
- You must have your Roth IRA for at least 5 years before you make a withdrawal
If you don’t qualify for withdrawal based on your age or how long you’ve had your account, have no fear, there are still exceptions to the early withdrawal penalty.
Exceptions to the Early Withdrawal Penalty
If you need to make an early withdrawal, but are under the age of 59 ½ or have not had your Roth IRA for at least 5 years, there are exceptions to the Roth IRA early withdrawal penalty.
You can avoid the Roth IRA early withdrawal penalty if you use the withdrawal:
- to pay for a first-time home purchase
- to pay for qualified education expenses
- to pay for birth or adoption expenses
- to pay for unreimbursed medical expenses or health insurance if you are unemployed
Unfortunately, if you don’t qualify for withdrawal or for the exceptions, you’ll have to pay taxes and penalties in order to withdraw from your Roth IRA.
Roth IRA Withdrawal Penalties and Rules to Consider
It is advisable, if possible, to avoid making an early withdrawal from your Roth IRA. Even though you can withdraw up to the total of your contributions at any time, once you have withdrawn your contributions, you will be hit with taxes and penalties if you don’t meet a qualified withdrawal or are under the age of 59 1/2. There may still be penalties if the account is younger than 5 years too.
Once you start dipping into your account’s earnings, it may be subject to a 10% early distribution penalty because that amount is considered taxable income and therefore the money would be treated as income.
Another thing to consider is the tax implications associated with a Roth IRA. If you contribute to your Roth IRA and then decide to withdraw within the same year, the contribution you make is treated as if it were never made as long as the distribution is taken prior to your tax filing date. However, keep in mind that you would have to report those earnings as investment income.
Pros and Cons of Withdrawing
When it comes to withdrawing, there are pros and cons to consider before making a decision. Weigh your choices and decide whether withdrawal is the best option for you.
- Roth IRA withdrawals are tax-free and penalty free when withdrawing contributions
- You can possibly avoid the tax and penalty associated with early withdrawal in certain situations
- Most of the time, early withdrawal of the portion of the distribution allocable to earnings may be subject to tax and it may be subject to the 10% additional tax
- Once you withdraw, you cannot pay back the money to your IRA account
- If you withdraw early, you will miss out on years of growth
- Roth IRAs are investment accounts that are non-tax deductible, but qualified withdrawals are tax and penalty free
- To qualify for a withdrawal from your Roth IRA, you must be over the age of 59 ½ and have the account for at least 5 years
- If you don’t meet the qualifying requirements or the exceptions, your earnings may be subject to a 10% early distribution penalty
- Once you withdraw from your Roth IRA account, you cannot pay back the money and you will miss out on years of growth in your earnings
With all that being said, the decision to withdraw from your Roth IRA should not be taken lightly. It is important to manage your money responsibly and make smart financial decisions so you can maintain your credit history.
Sources: Investopedia | IRS