“But it’s MY money. I already paid taxes on it!” That is true. Roth IRAs are funded with after-tax dollars. Therefore, Roth IRA withdrawals should be tax-free, right? Unfortunately, that is not always true.
What is a Roth IRA?
Roth IRAs were created by law in 1997. Rather than putting pre-tax dollars into retirement savings and kicking the taxes down the road until you are retired, you can deposit after-tax dollars and then pay zero taxes on it when you take it out. None of the growth is taxable for money taken out after retirement age (59 ½). Roth withdrawals do not count toward your income or raise your tax bracket in your retirement years. They cannot cause your social security to be taxable or repayable, and it can’t price you out of health insurance in the pre-Medicare years. Roth distributions are already your money and not income when you withdraw after age 59 ½. However, sometimes life throws you a curve and money gets tight.
Bad Things Happen
Bad things happen and you think about using money from retirement savings to fix it. I always discourage this. Every dollar you take out of retirement is another day you will have to go to work and keep up with people half your age. Retirement age will sneak up on you along with backaches, fallen arches, grandchildren, and a lot of other reasons why you just don’t want to go to work anymore. Once you take money out of retirement, it is very hard to get your savings back to the level it would have been if you left it alone. The IRS is aware of this and they charge a steep penalty for early withdrawals from retirement. Technically, this is not because they care about you retiring, but because long-term investments are good for the economy. In any case, your retirement funds are not your emergency fund, and early withdrawal penalties apply to Roth IRA withdrawals to some degree.
Calculating the Tax and Penalties
If you withdraw money from your Roth up to the amount you contributed (deposited), there is no tax or penalty on the withdrawal. When you withdraw money, the money you deposited comes out first and any growth (interest, dividends, and other gains) comes out last. What would be taxable? There are two rules that make Roth withdrawals taxable. First, if you are not yet age 59 ½ at the time of the withdrawal, any growth you withdraw is taxable income. Second, regardless of your age, if you haven’t had your Roth set up for at least five years prior to the withdrawal, the growth is taxable income. Why? Again, retirement funds are meant for long-term investments and not as an emergency fund. Am I subject to early withdraw penalties? Yes, but again, only on the growth that you withdraw and only if you are under age 59 ½. Remember that ALL your deposits come out first, then you withdraw the growth. If you are only taking back money that you deposited, it is not taxable or subject to penalties.
Who keeps up with this information?
The bank or financial institution where you keep your account keeps records of your deposits. They will send you a 1099-R at the end of the year if any of your withdrawal was taxable or any penalties apply. If you change banks over the years, the new bank will NOT have records of your deposits in the other bank. When you “rollover” from one bank to another, sometimes the information is lost on how much is deposits and how much is growth. It is ALWAYS the taxpayer (you) that is ultimately responsible for keeping the records. The bank is not your mom or your accountant. They are not going to help you do your taxes. You should always keep records of all your Roth contributions. Some information should never be thrown away. Keep all Roth deposit records until you reach retirement age.
What about my Roth at work?
Is my employer matching after tax dollars? No. If you are contributing to a Roth 401k at work, the employer match money is pre-tax dollars in a separate account. The money contributed or matched by your employer is not in a Roth. That part is tax-deferred funds and will be taxable when you withdraw it at any age.
Summing up
Your money is your money. You can withdraw the money that you deposited into your Roth at any time. The growth can be taxable income, even after retirement age. Early withdraw penalties are assessed only on the growth. Finally, keep records of ALL Roth deposits until retirement age, especially if you move your money from one bank to another. .
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More on basic money issues:
Your Tips Are Your Money – Managers should not take your tips
What’s All this Stuff Taken out of My Paycheck?
You can learn more about Roth IRAs on the IRS website
