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Roth IRA Distribution Tip

The stock market selloff in fall of 2011 caused me to reassess my situation: as I've retired relatively young from regular employment to invest & trade full time, I might eventually face a serious cash flow problem. By having all my money (except for a year's living expenses) tied up in stocks, if the market did not recover timely I could eventually be forced to sell securities at a loss just to pay my bills. If the market tanked for years I could be in real trouble and watch my life savings wither. In fact, in recent years I had quit making contributions to my Roth IRA-my thinking being that if I ever did need to liquidate stocks prior to age 59½, then why suffer the early withdrawal taxes and/or penalties?

That was a big mistake-I should have continued my annual Roth contributions. Researching IRS Pub 590 on IRA's just now has enlightened me to some very good news that I didn't know: the tax law generally allows taking early distributions (after 5 tax years) from a Roth IRA up to the amount of your accumulated contributions without tax or penalty. The tax-free status makes sense because you've already paid income tax on the amounts you've contributed to a Roth,1 but the penalty-free status came as a big surprise. The exact verbiage on taxability from IRS Pub 590, Ch. 2 under the heading "Are Distributions Taxable?" is:

You generally do not include in your gross income qualified distributions or distributions that are a return of your regular contributions from your Roth IRA(s). You also do not include distributions from your Roth IRA that you roll over tax free into another Roth IRA. You may have to include part of other distributions in your income. See Ordering Rules for Distributions, later. [bold mine]

Most people probably skip over the brief bit of text that I have bolded from within the lengthy Pub 509, to focus on the rather extensive rules for "qualified distributions." "Qualified distributions" from a Roth IRA that are made before reaching age 59½ involve being disabled, transfers on death, or the first time home buyer exception as shown in this nifty IRS flowchart (from Pub 590):2

But the idea that any flowchart-rejected unqualified early distributions could be free of tax or penalty (once they've sat in the Roth for just 5 tax years) was news to me. So I did further research in IRS Pub 590 and Form 8606, on penalties and found absolutely nothing for Roths. Searches within Pub 590, Chapter 2 (Roth IRAs) revealed that the Roth chapter does not even contain the words "penalty," "penalties," "10% tax," or "additional tax." I then did a double check on the web on the subject of penalties for Roth IRAs. Yep, everything I've read corroborates that there are no penalties on early withdrawals up to your accumulated contributions amount, provided those contributions have sat in the Roth for 5 years. One Motley Fool article gives a case study example. (Scroll down in the article to Example #4 with Rick.)

Long ago I learned that when trying to verify whether a choice I may be making has tax consequences or not, one of the quickest and surest ways is to simply work through the appropriate IRS Form that you would attach to your 1040. In this case it is Form 8606 which figures any tax on early distributions from a Roth IRA. For my readers, I've condensed the essence of Form 8606 into a quick and easy Excel spreadsheet you can download here.3 My condensed spreadsheet version of Form 8606 boils it down to just a few basic numbers that many people can simply estimate off the top of their heads and likely come up with a pretty good idea as to whether or not they'll have any tax on an unqualified distribution. As for the 10% "additional tax" [penalty] referred to in the flowchart, the verbiage in the tax code seems murky and scant. I could not find anything on the 5 tax year rule as cited in the Motley Fool article for unqualified distributions. But Form 8606 did not have me calculating any penalty for early withdrawal, so that is promising. I could not find clear language on penalties in the code, so I phoned the IRS helpline.

If you're concerned that job loss or some other unforeseen circumstance could leave you short of cash long before 59½, and that fact is keeping you from maxing out your Roth IRA contributions, you might want to think again. If your Roth situation is more complicated than mine (due to conversions or previous early distributions, etc.) you'll certainly want to work through a Form 8606 more carefully. But if your situation is relatively straightforward, my spreadsheet will save you tons of time. You can always start with my spreadsheet and then dig deeper into the tax code only if you are unsure. I am not a tax professional, though, so if there is any doubt at all about your situation I'd consult your tax advisor, or call the IRS helpline at 1-800-829-1040 just to be sure.

1 unlike a traditional IRA where you get a tax shelter at the time of contribution.

2 there is also a one-time qualified distribution from any type of IRA allowed to fund a Health Savings Account (NYSE:HSA) for a maximum of one year's HSA contribution limit.

3 earlier MS Office 2003 version here in case you don't have Office 2007 or later.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.