Every Roth IRA account owner knows that the main benefit of the Roth IRA is that there are no taxes due on Roth IRA withdrawals taken after the account owner is 59 ½. However, what taxes or penalties apply to distributions taken before the Roth IRA owner reaches 59 ½?
If the Roth IRA owner takes a distribution before they are 59 ½ then the IRS will require taxes and an early withdrawal penalty of 10% on any investment gains or income that were not Roth IRA contributions or Roth IRA conversions. IRC § 408A(d)(2)(A) & Treasury Reg. §1.408A-6, Q&A-1(b). In essence, what happens when a Roth IRA owner takes distributions before age 59 ½ is that the amounts distributed must be separated into two categories. These two categories determine whether the amounts distributed will be taxable and subject to penalties or whether they come out tax free. The first category is Roth IRA contributions and Roth IRA conversions. These categories are distinct from the rest of the account because these amounts have been subject to tax before the funds were included in the Roth IRA. The amounts withdrawn that do not exceed the amounts of Roth IRA contributions or Roth IRA conversions are not subject to taxes or penalties upon early distribution from the Roth IRA. However, any amounts distributed in excess of the Roth IRA contributions or Roth IRA conversions, which would typically be the investment returns, are subject to taxes and the early withdrawal penalty of 10%.
For example, let’s say a Roth IRA owner is 45 and has a Roth IRA with $65,000 in it. This balance consists of $15,000 in Roth IRA contributions, $20,000 in Roth IRA conversions, and $30,000 in investment returns. If the Roth IRA owner took a distribution of the entire account then $35,000 would NOT be subject to early withdrawal penalties as this amount comprised Roth IRA contributions and Roth IRA conversions where taxes have been paid already. However, the remaining $30,000 distributed represents investment returns/gains made in the Roth IRA and would be subject to early withdrawal penalties of 10% and must be included in the taxable income of the Roth IRA owner. As a result, Roth IRA owners under age 59 ½ should avoid distributions of their ROTH IRA in excess of their contributions and conversion amounts.