As readers may know, Roth plans allow you to contribute after-tax income, with qualified withdrawals (including earnings) being tax-free in retirement. In contrast, traditional (tax-deferred) plans usually offer tax-deductible contributions, with withdrawals taxed as ordinary income when you retire.
Choosing between a Roth or tax-deferred plan depends on a variety of factors, including your current tax situation, future income expectations, and financial goals. For younger generations, one major benefit of the Roth IRA is an ability to access contributions before age 59.5 without paying taxes or a penalty. Yes, this is possible!
As background, a disadvantage with tax-deferred plans is the inability to access funds before age 59.5 without incurring a 10% penalty. When you combine tax owed with the penalty, an early withdrawal can be devastating to your retirement savings plan. Exceptions may allow you to avoid this penalty, but they apply in rare situations.
To the contrary, generally, in a Roth plan, withdrawals of your original contributions are not taxed and penalty-free. Why? Because they are made with after-tax dollars. Although a Roth account should be viewed first as a retirement savings plan, this feature can instill participants with more confidence in making these contributions, as they would typically be available without tax or penalty as a last resort or in an emergency.
So, how would you know you are withdrawing contributions? For a Roth IRA plan, you categorize the Roth account into three buckets. The sum of these buckets equals the total account value:
Regular contributions;
Conversions and rollover contributions; and
Earnings.
Fortunately, Roth IRA ordering rules consider any distributions to be a return of contributions first, followed by conversions and rollover contributions on a FIFO (first-in, first-out) basis, and lastly, the earnings. As a result, so long as your total contributions are equal to or more than your total distributions, the distribution from your Roth IRA will not be taxed or penalized.
If you are looking to distribute converted funds, the rules are more complex. For instance, if you are under age 59.5, a penalty may apply if the funds do not remain in the Roth IRA account for a five-year holding period. In light of the nuances, an adviser consultation may be warranted if you are working on a conversion strategy.
Also, the ordering rules above apply to Roth IRA plans. If you participate in another type of employer-sponsored plan with a Roth feature, you want to review the specifics of your employer's plan before making distribution decisions.
Life happens. Recent reports show that participants are withdrawing early from their retirement accounts at record percentages. And, paying record amounts in IRS penalties.
When making the decision between a tax-deferred and Roth retirement plan, I encourage you to consider early access to contributions afforded by the Roth plan as a factor in your decision-making.
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