There are two types of Roth IRA distributions: qualified and non-qualified. It’s important to understand the difference.
Qualified distributions from your Roth IRA generally require that the account is at least five years old and that you meet one of the following requirements:
- Over 59½
- Making a first-time home purchase
- Disability or death
What happens if you withdraw earnings that don’t qualify as a proper Roth IRA distribution?
Qualified or Non-qualified Roth IRA Distribution?
Withdrawals that don’t fit the criteria above are generally classified as non-qualified Roth IRA distributions.
However, there are a number of exceptions to the rules of Roth IRA withdrawals.
The most important rule: You are allowed to withdraw any contributions that you made to a Roth IRA tax free and penalty free, at any age and without the account needing to be five years old. (This applies only to your contributions; the earnings your account generated on those contributions are not included.)
There are other important exceptions that allow you to withdraw both the contributions and the earnings early and free of tax. These include education expenses and unreimbursed medical expenses. There is also an exception that allows investors to withdraw money early through annual distributions using Rule 72(t).
All other withdrawals from a Roth IRA that do not meet these criteria are considered non-qualified Roth IRA distributions. Investors must pay both taxes and early-withdrawal penalties on non-qualified funds they withdraw.
Understanding How Withdrawals Are Calculated
The Internal Revenue Service categorizes withdrawals from a Roth IRA in a specific order. When you make a withdrawal from any of your Roth IRAs (if you have several accounts), the first withdrawals you make are considered to be your contributions. This allows you the most flexibility and saves you from taxes and potential penalties when you start withdrawing your money from a Roth IRA.
Next, the IRS considers withdrawals you make after you have exhausted the limits of your contributions to be conversion contributions from a Traditional IRA or a 401(k) retirement plan. If you made conversion contributions, these contributions are calculated on a first in, first out basis.
Finally, any other withdrawals that are made are considered to be from your Roth IRA’s earnings. These must be a qualified withdrawal as described above or one of the specified exceptions. If they do not fit into one of these categories, they are considered non-qualified Roth IRA distributions.
What Happens When You Make a Non-qualified Roth IRA Distribution?
Non-qualified Roth IRA distributions are taxed as ordinary income. In addition, you will have to pay a 10% early withdrawal penalty if you are younger than 59½. These can add up to a considerable sum, with the potential to erode 40% to 50% of your investment, depending on your tax bracket at the time of withdrawal.
Holding your Roth IRA funds until retirement is, needless to say, the best approach for your financial health. But if you do have to take an early distribution, understanding the rules that determine whether it is a qualified or non-qualified Roth IRA distribution will minimize the amount of taxes and penalties you may have to pay.