Out of the many retirement tools available to Americans, few have grown as rapidly in popularity as the Roth IRA. As of the end of 2015, Roth IRAs had an aggregate of $660 billion in assets, and I would surmise this figure is only set to grow.
The beauty of the Roth IRA
The biggest advantage of the Roth IRA is its back-end tax benefits. Unlike its partner in crime, the Traditional IRA, a Roth IRA has no upfront tax benefits. Contributing $5,500 a year in 2017 if you're 49 years of age or under, or the maximum of $6,500 (an added $1,000 catch-up contribution for seniors) if you're 50 and up, will have no bearing on your current-year tax liability.
However, earnings within a Roth IRA account are allowed to grow completely tax-free for life since money contributed to a Roth is considered after-tax. This is the real beauty of the Roth IRA, since any qualified withdrawals made after age 59-1/2 won't count toward your adjusted gross income. In other words, a Roth IRA is a great way to keep your tax rate down in retirement, especially if you expect your income or tax rates to grow during your golden years.
Other favorable reasons to open a Roth include the ability to continue making contributions after the year in which you turn 70-1/2, which is something not allowed with a Traditional IRA, and the lack of a required minimum distribution (RMD). Traditional IRAs require the accountholder to withdraw a certain percentage of their account value every year or face a steep penalty. Roth IRAs have no RMD, allowing the accountholder to withdraw as much as he or she wants, when he or she wants. It's also possible to leave a Roth untouched so it can be passed along as an inheritance.
One of the few times a Roth IRA can come back to sting is if you make a non-qualified withdrawal before turning age 59-1/2. If you take money from your Roth before reaching the qualified retirement age, you'll owe federal tax on the earnings you've made, as well as pay a 10% penalty to boot.
Roth IRA withdrawal exemptions before age 59-1/2
However, there are a small number of exemptions that allow an individual to take money out of their Roth IRA before reaching age 59-1/2 without having to pay a penalty, and in some cases federal income tax as well. If one of these applies to you, your Roth IRA could be an emergency source of cash.
1. Your contributions
Another prime advantage of the Roth IRA that wasn't mentioned above is the ability to pull your contributions back out at any time, for any purpose. Remember, contributions to a Roth IRA are after-tax dollars, meaning you're free to take back your contributions at any point in the future, regardless of your age. Here's the catch: you won't be allowed to take any of the earnings you've made from your initial contributions. If you do, prepare to open your wallet to cover the federal tax implications and the associated 10% penalty.
2. First-time home purchase
An accountholder can also withdraw up to a maximum of $10,000 from their Roth IRA over their lifetime for a qualified first home purchase. In addition to the accountholder, this withdrawal also works if it's for the accountholder's children or grandchildren (in case you've already purchased a home). If used for a first-time home purchase, you won't owe any taxes or the 10% penalty.
3. College expenses
Your Roth IRA could also be your own personal college piggy bank if the money is used for qualified higher education expenses, such as tuition fees and textbooks. It can also include room and board if you're a full-time student. This exemption exists for you, your spouse, your children, and your grandchildren. The catch is that withdrawing money from a Roth for higher education purposes only skirts around the 10% penalty. In other words, you'll still be responsible for paying federal tax on any earnings generated from your contributions.
4. Unreimbursed medical expenses
If you have some hefty medical bills, you may also be able to tap your Roth IRA on a penalty-free basis. If you're under the age of 59-1/2, and your unreimbursed medical expenses top 10% of your adjusted gross income, you can make a Roth IRA withdrawal to help pay your medical bills. It's worth noting that despite having the 10% penalty waived, you will still owe federal tax on your withdrawal for unreimbursed medical expenses.
5. Medical insurance premiums following job loss
Another way you can tap your Roth IRA capital without paying a penalty or federal taxes involves recently losing your job. Tens of millions of Americans gain health coverage through their employer, and losing your job can make maintaining your health coverage tough. Luckily, you can withdraw money from your Roth IRA to pay your health insurance premiums so your coverage doesn't lapse.
6. You're disabled
Should you become disabled, you may be able to make completely tax-free and penalty-free withdrawals from your Roth IRA, even if you're not age 59-1/2. The one caveat is that the money you're withdrawing has to be "qualified" and meet the five-year rule. In layman's terms, this means contributed money must remain in your account for at least five years before it can be withdrawn due to disability without federal taxation or penalty.
7. An IRS levy
Last but not least, if you have past-due federal taxes, the Internal Revenue Service can seize assets held in an IRA, including a Roth IRA, to cover the balance of your past-due amount. The accountholder can also address the IRS levy head on by withdrawing assets from their Roth IRA to pay the past-due taxes. Both scenarios result in a tax-free, penalty-free withdraw; but let's face it, neither scenario is good news.
A Roth IRA should first and foremost be considered a foundational retirement building block. But if you need money in a pinch and meet one of the aforementioned exemptions, withdrawing from a Roth IRA could be worth your consideration.