- Are you wondering if you should put more money into a Roth IRA, a Roth 401(k), a Roth 403(b), or a traditional 401(k) / 403(b)?
- Do you worry about tax rates increasing in the future?
- Do you wish you could access more of your retirement money tax-free and penalty-free?
If you answered yes to any of the above questions or are curious about how Roth IRA withdrawal rules differ from 401(k) and 403(b) accounts, this blog post is for you!
Building wealth in a Roth IRA account is one strategy many people use to achieve their goals.
While I can’t give you advice on using Roth IRAs to achieve your goals without a financial plan, I can help you understand three important topics regarding Roth IRA accounts:
- How to take tax and penalty-free withdrawals (even before age 59 ½!) from Roth IRA accounts
- Comparing Roth IRA withdrawal rules to 401(k) and 403(b) accounts
- How to understand if you should add funds to a Roth account to help minimize your lifetime tax bill
How to take tax and penalty-free withdrawals (even before age 59 ½!) from Roth IRA accounts
Withdrawing money out of a Roth IRA tax-free, and avoiding a nasty 10% penalty, requires following some simple guidelines:
- Take withdrawals on or after the day you reach age 59 ½
- Take withdrawals after a five-year holding period
The five-year hold period begins with the first tax year you made the contribution to your Roth IRA. For example, if you contribute $6,000 on April 15th, 2021, for the 2020 tax year, the five-year period actually begins on January 1st, 2020!
- Qualify for an exception
You may not have to pay the 10% penalty (i.e., additional tax) in the following situations:
- The distributions are less than your qualified higher education expenses
- Your distribution is used to purchase, build, or rebuild your first home
- You experience a total disability
- You’re the beneficiary of a deceased Roth IRA owner
- You have unreimbursed medical expenses that are more than 7.5% of your Adjusted Gross Income (i.e., AGI).
- The distribution is due to an IRS levy on the retirement plan
- The distribution is a qualified reservist distribution
- The distribution is a removal of principal contributions and doesn’t include any gain or earnings from the account
The last exemption gives taxpayers great control over and access to their Roth IRA savings. Let’s look at one example of how money can be withdrawn from a Roth IRA penalty-free before age 59 ½.
Sally has contributed $6,000 / year to her Roth IRA for the last four years, for a total of $24,000. Her Roth IRA account has grown to $35,000.
Sally is 48 years old and needs $20,000 to make a down payment on a second home, her dream cabin on a lake in northern MN.
Sally can withdraw up to $24,000 from her Roth IRA penalty-free. If she withdrew more than $24,000 from her Roth IRA account, she would be subject to the 10% penalty since she is not age 59 ½.
Comparing Roth IRA withdrawal rules to 401(k) and 403(b) accounts
The IRS has different withdrawal and taxation rules when comparing Roth IRAs with other retirement accounts. The chart below provides an overview of these rules:
What are the differences with loans?
As a last resort, some people may want to access or borrow funds from their retirement accounts to survive a hardship.
Many 401(k) and 403(b) accounts offer loans and limit the loan amount to $50,000 or half the account balance. Loans often have processing fees, administration costs, and interest that you need to repay within a specific time period. The loan may be due in full if employment terminates, or taxes and penalties may apply.
Unlike 401(k) and 403(b) accounts, the IRS does not permit loans from Roth IRA accounts. However, the IRS has a 60-day withdrawal rule that allows you to take a withdrawal from a Roth IRA (without penalty) as long as you get the funds back into your account before the 60-day period is up.
How to take withdrawals from a Roth IRA before age 59 ½
The vast majority of 401(k) plans that I’ve seen don’t allow you to take withdrawals before age 59 ½ unless there is a hardship, such as a disability. If the plan allows for withdrawals from a 401(k) or 403(b) account, the withdrawal can be subject to income taxes and a 10% penalty.
Qualifying withdrawals from Roth IRA accounts before age 59 ½ can be tax-free if certain conditions are met (see above).
Also, the IRS allows an IRA or Roth IRA owner to access funds in their account (including earnings) without a penalty through a Substantially Equal Periodic Payment (or SEPP).
Through this rule, an account owner basically has to take a series of payments until age 59 ½ or for at least five years (whichever is longer). The IRS has three methods you can use to determine how payments will be made and how much you could access from your account before age 59 ½ without a penalty. This option is not available through a 401(k) or 403(b) plan.
Income Taxes on Qualifying Withdrawals
Income taxes are due when you take money from a tax-deferred 401(k) or 403(b) account. However, no income taxes are due on qualifying Roth IRA withdrawals. Additionally, your beneficiaries receive Roth IRA proceeds income tax-free. Giving a tax-free Roth IRA account to loved ones can be a great gift, especially if they are in a higher tax bracket!
Required Minimum Distributions (aka RMDs)
Once you reach a certain age, Uncle Sam wants you to “pay the man his money.” If you reached age 70 ½ in 2020 or later, you must take your first RMD by April 1st of the year after you reach 72. If you reached 70 ½ in 2019, the prior rule applies, and the first RMD was due by April 1st of the year after you reached 70 ½.
RMDs are based on your life expectancy. If you’re expected to live 20 years, you’ll need to withdraw 1/20th of your account value during your first RMD (plus earnings). The IRS forces you to take distributions out of your 401(k) and 403(b) accounts at the required age. These distributions are known as Required Minimum Distributions or RMDs.
Generally, the required minimum distribution is calculated by looking at your balance on December 31st of the prior year and then dividing that by your life expectancy. When you withdraw money from a tax-deferred 401(k) or 403(b) account, income taxes are due on the withdrawals. Make sure you or your advisor have a process to take your RMD every year when they are due on your retirement accounts and your inherited IRA accounts.
If you fail to take your RMD, the penalty is a whopping 50% tax on the amount that was not withdrawn!
Unlike 401(k) and Roth 401(k) accounts, you do not need to take RMDs from your Roth IRA! Funds in your Roth IRA account can continue to grow tax-free for yourself or your heirs. If you have questions about RMDs, check out some FAQs here.
Should you add funds to a Roth account to help minimize your lifetime tax bill?
Deciding if you should add funds to a Roth account is a complex question. In our previous post, we covered this topic in depth. Just remember that adding funds to a Roth account is only one of dozens of strategies that could help to lower your tax bill.
Are you worried you’re paying unnecessary taxes or missing opportunities to lower your tax bill? Take our free Tax Minimization Assessment to explore options to keep more of your hard-earned money so that you have more for what matters. Or, schedule a 90-minute, no-obligation consultation with me. For the last 19 years, I’ve been working hard to help my clients learn how they can minimize their tax bill and gain more control over their wealth. I’d love to help you too!