Roths can suit a variety of financial needs and goals
The Roth IRA was designed as a retirement plan, to help Americans save for the days when they’ve kissed full-time employment goodbye. But, unlike its traditional IRA cousin, it’s a flexible account, and its very flexibility allows it to be used for other financial goals.
The United States government allow individuals to take distributions from their Roths at times and for reasons unrelated to retirement. Account-holders can always withdraw a sum equal to their contributions penalty- and tax-free, of course. Typically, though, they cannot withdraw any earnings (including interest and income) from a Roth IRA until they are 59½ years old. In addition, the account has to have been in existence for at least five years. If they are under the magic age of 59½, such an early withdrawal is considered a non-qualified Roth IRA distribution. And these are subject taxation by the Internal Revenue Service (IRS), plus a 10% penalty.
But, as we said up top, Roths are flexible. A few situations do permit you to withdraw earnings, without getting dinged, even if you’re younger than 59½. Or to use the Roth for other things. Let’s explore.
1. Use a Roth IRA for a Home
You may take an early withdrawal—both penalty and tax-free—of earnings from your Roth IRA to buy a residence. Now, there are some terms and conditions to this. First of all, you’ll have to have owned the Roth for five years. The money you withdraw must be used directly for purchasing the home, like for a down payment or for closing costs. And it has to be your first home (which the IRS defines as the first home you’ve owned within the last two years). Finally, the amount in earnings that you withdraw is limited to $10,000 worth in earnings (though the IRS counts withdrawals as coming from contributions first, remember; only when that sum is exhausted does it start counting as earnings).
2. Use a Roth IRA for College
Roth can be used as a college savings account. You’re allowed to withdraw money for “qualified education expenses,” of the post-secondary school nature. The provisions for education are not quite as generous as for a first-time home purchase: If you do dip into earnings, you have to pay taxes on the amount you take out. However, you do avoid the 10% early withdrawal penalty.
Qualified education expenses are tuition, fees, books, supplies, equipment, computer costs and room and board (in most cases). You can use the funds for educational expenses for yourself, your spouse, your children, or your grandchildren.
Now, the assets within your Roth IRA don’t count if you apply for financial aid. However, any actual withdrawals do have to be reported as income on the following year’s application. So be careful they don’t mess up anyone’s eligibility.
3. Use a Roth IRA for an Emergency
You should have an emergency fund in place to help you in the event of an emergency. In fact, most financial planners recommend that you should have three to six months of living expenses saved in an emergency fund. But, what if you don’t have an emergency fund available or if the emergency costs more than you saved?
For true emergency, money from your Roth IRA can help. If you need to take out earnings for unreimbursed medical expenses that exceed 10% of your adjusted gross income (in 2019), you can do so without incurring the penalty (though you will owe taxes). Same goes for paying health insurance premiums if you’ve lost your job and are unemployed.
For other hardship situations, prematurely withdrawing your earnings incurs both the 10% penalty and taxes. So try to keep that within the amount you’ve contributed.
4. Use a Roth IRA for Estate Planning
Unlike other retirement accounts, you never have to take distributions from a Roth. That makes the account an ideal way to leave money to your heirs. Whoever you name as the beneficiary of the Roth can take possession of it upon your death (and proper documentation of same); no need to wait months for a probate court to process your will.
Unless you’ve put it in an irrevocable trust, the Roth IRA could be subject to estate tax (assuming your estate is large enough to qualify). However, it is not subject to income tax, assuming the account is at least five years old. Beneficiaries other than a spouse do have to start withdrawing funds from the account—usually at a rate determined by their life expectancy—but the minimum required amount is usually small. So you’ve left them a tax-advantaged account of their own.
One of the best features of a Roth IRA is its flexibility. Senator William Roth and his committee developed the retirement plan to suit several facets of the American Dream. With a Roth IRA’s flexibility, you can withdraw money to fund different financial goals that you may have, but consider all of these very carefully: You are losing not just the money you saved but all the interest it would have earned if you’d left it alone.