Consequences of Roth IRA Early Withdrawal

Dan asks:
My daughter, Lynn invested $2,000 (a gift from me) into a Roth IRA account in 2003. She now wants to use this money to purchase a car. What are the consequences of an early withdrawal?

Lynn was able to use your gift to open a Roth IRA because she also had $2,000 of her own earned income during 2003. Roth IRA contributions are made with after- tax dollars; once these monies are invested, earnings accumulate tax-free. If she keeps the money in her account until age 59½, she will then be able to withdraw money without incurring taxes or paying a penalty. If she withdraws money now, she can only withdraw money up to her original contribution tax and penalty free. She will owe income tax plus a 10% penalty on any withdrawal of account earnings. These earnings will be taxed at her marginal tax rate. The good news is with the recent market downturn she probably his little if any earnings in her account at this time.

Are there any possible scenarios in which Lynn could withdraw all her money, including earnings, without incurring a penalty?

Yes, Qualified Distributions are made both tax and penalty free. To be considered a qualified distribution, a Roth IRA distribution cannot be made before the end of the five-tax-year period beginning with the first tax year for which the individual (or the individual's spouse) made a contribution to the Roth IRA. This means even if you are age 59½ you must have held the money in the IRA at least five years for the withdrawal to be considered qualified.

In addition to the five-year holding period, there are several exceptions to the 10% federal early withdrawal penalty that generally applies to taxable IRA distributions taken prior to age 59½. These penalty exceptions generally apply to distributions taken for one of the following reasons:

· death of the IRA holder
· qualifying disability of the IRA holder
· certain medical expenses exceeding 7.5 percent of adjusted gross income
· health insurance if an individual has been receiving unemployment compensation for more than 12 weeks
· qualified higher education expenses
· qualified first-time homebuyer expenses
· conversion of Traditional IRA assets to a Roth IRA

Thus, if Lynn were to withdraw money to purchase her first home, her distribution could be considered a qualified distribution.

Also note Roth IRAs are different than Traditional IRAs in that they do not require minimum distributions. That is because Traditional IRA contributions are made with before-tax dollars. The IRS wants its money at some point, so they require you to start taking distributions by age 70 ½. There are no such requirements for Roth IRAs. You can keep the money in there until you die if you wish.