Roth IRA Penalties

What Roth IRA penalties are imposed by the IRS?

Knowing what penalties exist and how to avoid them is essential to your financial health and the future size of your retirement account.

Why?

Because the IRS imposes penalties on your Roth IRA if you violate the rules.

So how do you avoid penalties?

Easy. Make sure you follow the rules!

Knowledge of the Roth IRA basics is the key to properly funding your Roth IRA and realizing a seamless transition to retirement. So make sure to brush up on the fundamentals, like the Roth IRA rules, Roth IRA contribution limits, and Roth IRA withdrawals.

If you follow the rules, fund your Roth for at least five years, and wait until age 59 ½ before withdrawing any funds, then odds are you'll never have to worry about incurring a Roth IRA penalty.

Most Roth IRA penalties are classified as one of the following...

• Early Withdrawal Penalty
• Withdrawal In Less Than 5 Years
• Excess Contribution Penalty
• Improper Conversion Penalty
• Other Non-Qualified Distribution Penalties

The most common Roth IRA penalty is the early withdrawal penalty. And other than the excess contribution penalty, each of the above categories is essentially a hybrid form of the early withdrawal penalty.

Let's examine each Roth IRA penalty individually in order to understand what you need to avoid...

The Roth IRA Early Withdrawal Penalty

After you reach age 59 ½, most Roth IRA withdrawals are tax-free and penalty-free. But this isn't the case prior to age 59 ½.

Any funds withdrawn from a Roth IRA prior to age 59 ½ are classified as early withdrawals. Not all early withdrawals are subject to an early withdrawal penalty, but those that aren't are the exception rather than the rule.

In most cases, funds withdrawn from your Roth IRA prior to age 59 ½ will incur an early withdrawal penalty and sometimes income taxes as well.

So what's the early withdrawal penalty?

10% of any investment gains withdrawn.

Remember, your initial contributions can be withdrawn from a Roth IRA tax-free and penalty-free at any time.

Why?

Because your contributions were not tax deductible. You funded the account with after-tax dollars, so income taxes are not due on the funds you've already paid income taxes on.

For the most part, though, investment gains are only income tax-free if you wait to withdraw them after age 59 ½.

So what does this teach us?

The following...

Once you fund your Roth IRA, do everything within your power to keep your money invested and growing until you reach age 59 ½ at the least. Otherwise, you risk triggering an early withdrawal penalty. And that's just wasted money!

Roth IRA 5 Year Waiting Period

So are all Roth IRA distributions (withdrawals) after age 59 ½ tax-free and penalty-free?

No.

Unfortunately, your qualified distributions must adhere to one additional rule in order to avoid triggering a Roth IRA penalty or income taxes.

Your Roth IRA must be open and funded for at least five (5) years before any investment gains can be withdrawn tax-free and penalty-free.

Need an example?

Let's say you opened a Roth IRA in 2008 at age 57 and contributed $6,000.

In 2011, even though you're 60 years old, you can NOT withdraw any of the investment gains on the original $6,000 contribution without triggering a penalty and income taxes on those gains.

Why?

Because your Roth IRA must first meet the 5 year rule.

To withdraw investment gains tax-free and penalty-free, you'll have to wait until January 2013.

Why 2013?

Because 5 tax years will have passed by then... 2008... 2009... 2010... 2011... and 2012.

Remember, the IRS goes by the tax year, not the actual year, when calculating whether or not your Roth IRA has met the 5 year rule.

So make sure you fully understand the 5 year rule and all its nuances before taking any Roth IRA distributions.

Excess Roth IRA Contributions

Excess Roth IRA contributions also trigger a penalty...

What's the penalty?

An annual 6% tax on the excess contribution amount until the problem is corrected.

Fortunately, in most cases, this problem is easy to correct. If you discover you inadvertently made an excess Roth IRA contribution, as long as you withdraw the excess funds prior to the tax filing deadline for the year in which you made the contribution (April 15th of the following year), then you can avoid having to pay the 6% penalty.

So keep an eye on how much you're contributing. Erroneously making an excess contribution is neither rare nor difficult.

For instance, if you make regular monthly contributions to your Roth IRA and your income unexpectedly rises during the course of the year, then your contribution limit may change along with it, leaving you with an excess contribution.

So make sure you always remain aware of how much you're eligible to contribute and how much you are contributing. If you do, it should be relatively easy to avoid this penalty.

Roth IRA Conversion Penalty

The IRS makes an exception to the early withdrawal penalty when it comes to Roth IRA conversions.

For instance, let's say you're 40 years old and you have a Traditional IRA. Since you're not yet 59 ½ years old, withdrawing funds from your Traditional IRA at age 40 will, in most cases, trigger an early withdrawal penalty.

But if you convert your Traditional IRA to a Roth IRA, you won't have to pay a Roth IRA conversion penalty.

While the funds from your Traditional IRA will be treated as income on your tax return, you won't have to pay a penalty unless you then take a non-qualified distribution from your Roth IRA.

So there is no specific Roth IRA conversion penalty, but if you aren't careful with what you're doing when you make a Roth IRA conversion, you might inadvertently do something which will trigger an early withdrawal penalty from your Roth IRA.

So make sure you consult your accountant before taking any distributions you're unsure about.

Non-qualified Roth IRA Distributions

In addition to the penalty-triggering events outlined above, non-qualified Roth IRA distributions also trigger the early withdrawal penalty.

In order to guarantee you avoid an early withdrawal penalty, you need to make sure any withdrawals prior to age 59 ½ are qualified distributions.

How do you do that?

By knowing the difference between a qualified distribution and a non-qualified distribution.

Generally speaking, you need to meet the 5 year rule and reach age 59 ½ before you can make a qualified distribution. But there are exceptions...

Knowing what those exceptions are can make all the difference in the world by allowing you to withdraw funds from your Roth IRA prior to age 59 ½ without triggering an early withdrawal Roth IRA penalty, associated income taxes, or both.

So before making an early withdrawal, check to see if your distribution is qualified. If it is, you could save yourself quite a bit of money.

Conclusion

The key to avoiding Roth IRA penalties is knowledge.

Knowing and abiding by the rules and regulations which govern Roth IRAs is the best method available for avoiding an unexpected penalty or tax liability.

If you're unsure of the rules, or you just want the peace of mind that comes with professional advice, it's always a good idea to meet with your accountant or another tax professional to look over the details of what you're doing.

My advice?

Do your best to keep it simple...

Know how much you can contribute to your Roth IRA... And don't contribute any more than that.

Fund your Roth IRA steadily, year-after-year, and don't take any distributions until you reach age 59 ½ and you've been funding your Roth for more than 5 tax years.

Follow that advice, and it's highly unlikely you'll ever have to deal with Roth IRA penalties.