The Do's and Don'ts of IRA Withdrawals

Roth IRAs do not have any mandatory distribution requirements, but early withdrawal penalties still apply and are made even more stringent because of the five-year rule. Qualified distributions (where no income tax is due) from a Roth IRA must have been held for five tax years and must be made:

• After the age of 59 1/2, or
• When you die or become disabled, or
• For the payment of first-time homebuyer expenses.

In one sense, the penalties on distributions from Roth IRAs are not as severe as they may seem at first glance because of the ordering rules. These rules dictate that distributions must come first from the annual contributions over the years, then from conversion contributions and, finally, from earnings.

So, for example, if we start with a $4,000 contribution that has grown to $6,000 over the last couple of years and then withdraw $3,000 prematurely, that $3,000 comes from original contributions that have already been taxed, and there will be no tax or penalty due. If, however, we withdraw $5,000, then $1,000 is coming from earnings, which will then be subject to income tax and also subject to a $100 penalty.

Perhaps the more important factor in this instance is that the withdrawal is gone from the Roth IRA portfolio and the holder has given up tax-free compounding on that amount from that point until withdrawals take place in retirement.

Should you pass away with assets remaining in an IRA, it would clearly be advantageous for that IRA to be a Roth IRA. Traditional IRAs count as part of your estate, and beneficiaries will still have to pay income tax on the amount received. Roth IRAs are also counted as part of your estate. However, beneficiaries will usually be able to avoid any income tax on the amounts received.

If the beneficiary is the spouse, the Roth IRA remains totally intact with the same rules and regulations as were previously in place. If the beneficiary is someone else, he or she must take distributions by the end of the fifth year after death occurs or over the period of his or her own life expectancy on a regular basis. In either case, income taxes can be totally avoided.

Coming up next: Which investments work best in IRAs.