Withdrawals: Traditional IRA’s vs Roth IRA’s

If you have been growing a nest egg in an IRA account, it is best to never withdraw for reasons other than retirement. However, it is possible that you will be faced with unforeseen expenses and a withdrawal will be unavoidable.

If you withdraw from your traditional IRA before age 59½, the IRS normally labels your withdrawal “premature”. This means that you will face a 10% penalty on the amount which you take out of the account. Furthermore, you will be taxed on the money that you withdraw. However, there are two common situations in which the IRS allows you to use your retirement savings early without facing penalties.

The first exemption from IRS penalties is for school expenses. You can use your IRA dollars to cover the cost of tuition, books or supplies for you, your spouse, your children or your grandchildren. If the student enrolls more than half time, room and board expenses also qualify. As long as the college, university or other higher education organization is accredited you will not be assessed any penalty on your IRA withdrawal.

The second exemption is for homeowners. If you or your spouse are first time homebuyers (or did not own a personal residence during the last two years) you can use your IRA funds as a down payment. If you qualify, both you and your spouse can take out up to $10,000, giving you $20,000 to use towards your home.

The IRS also allows for qualified, penalty free distributions for military reserve members, as well as during hardship situations. However, these situations are less common and are surrounded by many regulations.

If you have a Roth IRA, the rules are slightly altered. This is because there are four types of funds in your Roth account. These funds are treated differently but the order of distributions always works the same way:

    1. “Regular Roth IRA Contributions”
      • Your contributions to your Roth account can be withdrawn tax free at any time.
    2. “Taxable Conversion Contributions”
      • Funds rolled over from traditional IRA’s are also tax free. However, you should be over the age of 59½ and have held your Roth account for 5 years to avoid the 10% penalty.
    3. “Nontaxable Conversion Contributions”
      • Nontaxable funds rolled over from a traditional IRA. These funds can be withdrawn tax free once the regular conversions and taxable conversions have been withdrawn.
    4. Roth IRA Earnings
      • Any Roth earnings are taxable. They are also subject to the 10% penalty if withdrawn before age 59½.

Tax exemptions for Roth accounts are fairly similar to traditional IRA’s. They allow exemptions for first time homeowners and for disability and death. However, unlike traditional IRA’s, Roth accounts do not allow a tax exemption for education expenses. Another major difference is that all distributions from a Roth IRA are tax free once the account is 5 years old and the owner is age 59½.

If you are unsure about whether any distribution qualifies or what penalties you may have to pay it is always a good idea to consult an accountant or financial advisor, regardless of what type of account you have. They will be able to explain the rules, provide valuable advice and assist you in your decision.