While a Roth IRA is an excellent retirement tool, there are many rules that have to be followed by investors. For example, you can only contribute $5,500 per year unless you are over the age of 50 years-old (when you can then invest up to $6,500 each year).

Another rule of Roth IRAs states that you cannot begin withdrawing earnings you’re your Roth IRA account until you are 59 ½ years-old although there are some exceptions to that rule for purchasing your first house or using the money for educational expenses.

Another regulation of Roth IRAs requires you to keep your money invested for five years before withdrawing it. Not following these rules can result in the consequences of taxes and penalties that must be paid. (Find out about the most important Roth IRA rules so you don’t make a mistake.)

The Rationale Behind A Five Year Wait

Roth IRA five year ruleRoth IRAs are a type of retirement account. Using them for anything other than saving and investing for retirement tends to defeat their purpose and what they were designed to be used as. By instituting a rule that investors had to wait at least five years before withdrawing their investment reinforced the notion that Roth IRAs were designed for long term investing and should not be use like a savings account. Even though investors can withdraw their investment without penalty for home purchases and education expenses, Roth IRAs were not designed to be used similar to an emergency fund, and our politicians thought that the five year wait would help deter people from misusing the investment vehicle.

What Happens If You Withdrawal A Roth IRA Before Five Years?

There are two types of distributions that are defined by the Internal Revenue Service (IRS) when it comes to Roth IRAs. You can either have a qualified distribution or an unqualified distribution. A qualified distribution is a legal distribution that was withdrawn from your Roth IRA after reaching the age of 59 ½, or it meets the qualification for an exemption to the distribution rules for items such as your first home purchase.

But, if you withdraw your earnings before they have been invested for five years, whether you are over the age of 59 ½ or not, your withdrawal will be deemed as an unqualified distribution by the IRS. Unqualified distributions of your earnings to a Roth IRA are subject to taxes at your current ordinary income tax rate and a 10% penalty tax as well. (Learn more about Roth IRA taxes) This can be a quite devastating additional tax that investors would have to pay. If you were in the 28% tax bracket, you would see 38% of your Roth IRA’s earnings evaporate in taxes and penalties because you withdrew the earnings before five years had passed.

One item of note is that the taxes and penalty for an early withdraw from your Roth IRA only applies to the amount of funds that were earnings or interest. Investors in a Roth IRA are permitted to withdraw their contributions at any time without tax or penalty. There are many rules that you must keep in mind when investing in a Roth IRA, and one of them that is most forgotten is the requirement that your contributions and their earnings must have been invested for five years or more. If you withdraw your earnings prior to the fifth anniversary, your proceeds will not be considered a qualified distribution, and you can face taxes and penalties.

Photo by losmininos via Flickr

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