When you talk about retiring early, you get a lot of questions about how you are going to fund it. If you answer that you are putting money into retirement accounts, the next question is inevitably about paying penalties. The “common wisdom” is that you won’t be able to take your money out of retirement accounts until you reach age 59.5 unless you are willing to pay big bucks in penalties.
The thing is…there are plenty of ways to withdraw money from a retirement account before age 59.5 without paying a penalty. I’ve already covered one, known as Substantially Equal Periodic Payments. Today, I want to talk about another method: withdrawing your contributions to a Roth IRA.
Why that specific topic? Well, in the comments on Monday’s post Josh asked this question:
I gave a short answer in the comments, but I wanted to expand on it here. Having access to your money is necessary for all retirees, of course, but this particular topic is one that may allow someone to retire earlier than they imagined.
Of course, you can withdraw money from your Roth IRA early for reasons other than early retirement. In fact, there are a lot of non-FIRE reasons why you might want to do this. For this particular quirk of the tax code, the reason doesn’t matter. Many tax code loopholes do have particular situations you need to be in to receive the money from your retirement account early. Not this one.
Normal Roth IRA Withdrawal Rules
First, let’s look at the rules for taking withdrawals from a Roth IRA under what we’ll call “normal circumstances” – that is, a qualified distribution.
Qualified distributions from a Roth IRA are tax-free upon withdrawal, including both the contributions and any earnings they’ve had. Qualified distributions are any payment or distribution from your Roth IRA that:
- Is taken at least 5 years after the Roth IRA was set up, and
- The payment or distribution is:
- Made on or after the date you reach age 59.5,
- Made because you are disabled,
- Made to a beneficiary or to your estate after your death, or
- Meets the requirements for a First Home exception (up to a $10,000 lifetime limit).
If you take a distribution that doesn’t meet those requirements, you may have to pay a penalty in addition to any applicable taxes.
Withdrawal of Roth IRA Contributions
The Roth IRA has a special rule that other retirement accounts do not have, however. You are allowed to withdraw your regular contributions to the Roth IRA, tax and penalty free, at any time. No matter how long you’ve had the money in the account or what you plan to do with it, this money is yours.
The reason for this is that the IRS says:
You do not include in your gross income qualified distributions or distributions that are a return of your regular contributions from your Roth IRA(s)”
Boom! Thank you, IRS. This is the way that you are able to pull money out of your Roth IRA without meeting the normal qualified distribution rules, and without having to pay taxes or penalties.
Reasons To Withdraw Roth IRA Contributions
There are a variety of reasons you might want to withdraw your Roth IRA contributions before age 59.5. This is just a partial list.
- Supplement your income in early retirement. Of course, this is the reason that brought us here. Withdrawing your Roth IRA contributions during the early part of your retirement, when you can’t necessarily take money out of other accounts, can help you fund those extra years.
- Use it as an Emergency Fund. This one is a bit risky, because you can’t predict whether an emergency will happen while the market is up or down. But, if you have an emergency and your normal emergency fund won’t quite cover it, this is an option. Proceed carefully.
- Replace a 529 Account. This deserves its own post, but you could save money in a Roth IRA instead of a 529 plan to pay for education expenses. I’ll talk about this in the future (keep an eye out) but it’s a way to save money for college that can also be easily used for retirement if for some reason you don’t need the money for education expenses.
Things To Think About
You didn’t think this post was going to be 100% upside, did you? Sorry. Tax code doesn’t usually work that way! Here are some things to keep in mind if you want to consider withdrawing your Roth IRA contributions.
What you are giving up
First, remember that withdrawing your contributions means they are no longer invested and earning you money. Your earnings, which you should be keeping in the Roth IRA, can keep earning money, but what you withdraw will not. This means less money is earning you money in your sleep. Bummer. Because of this, you don’t want to withdraw money from your Roth IRA just to fund a fun purchase. Make sure you need the money. If you need that money for retirement, think long and hard before taking it out to do anything else.
By the same token, you can’t necessarily put that money back into the Roth IRA if you decide you don’t need it. Your annual contribution limit will not change because you took money out. So if you take $5,000 out in 2017 and then end up not needing it, you don’t get to put an extra $5,000 back into your Roth IRA. The normal annual contribution limits still apply. The only way to put that money back into the Roth IRA would be if you aren’t already maxing out your account.
Tracking Roth IRA Contributions
Second, you need to be very careful tracking how much money you put into your Roth IRA, and how much you’ve taken out. You don’t want your withdrawals to exceed the amount of your contributions, because of course you will then be looking at possibly paying taxes and penalties.
I track my Roth IRA contributions two ways. First, I enter them when I file my income taxes for the year. Though contributions to a Roth IRA don’t help me lower my taxable income, this is a good place to document that contribution. I also receive annual IRA reports from my brokerage, which also documents the contributions for the previous year. I generally receive these the last week of January every year.
When you take a distribution from your Roth IRA, the order in which you take money out is predetermined in the tax law. Your regular contributions are going to come out first. So when (if) it comes time to take a distribution of your regular contributions, and it’s not an otherwise qualified distribution, you will want to have this information handy:
- Any regular contributions you’ve made in the current year
- Your total regular contributions from previous years
- Any prior distributions
Your distribution can be up to the amount of your current and prior year contributions, minus any previous distributions. Any more than that and you might be paying a penalty.
So that’s another method to pull money out of your retirement accounts early, without triggering taxes or penalties. I’ll continue discussing these loopholes in future Finance Friday posts. Have any questions? Put ‘em in the comments!
Gentle reminder: I am not a personal finance professional. You should always do your own research before making changes to your finances. Talk to a professional if you need additional help. Please read my full disclaimer here.
Great post! Another point is that with FIRE, a Roth is the end goal anyway. Mad Fientist gives plenty of evidence as to why investing in a Traditional IRA is optimal for FIRE, but the goal is to do a conversion ladder to put it in a Roth anyway.
Plus, there is a more practical reason why you should invest in a Roth: you might not have a choice. If your income is above $65,000 and your company provides a 401(k), bye bye traditional, you’ve gotta do Roth.
D’oh! I completely missed the opportunity to talk about contribution rules and how it might be your only option for an IRA! Thanks for including that!
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