Can I Really Withdraw My Roth IRA Contributions At Any Time Without Tax Or Penalty?
This is a follow-up to my recent post Roth IRA Contribution vs. Emergency Fund Savings, where I suggested that people should just fund their Roth IRAs first over an Emergency Fund. Basically, this is because anyone can withdraw their Roth IRA contributions at any time, without penalty. (Not earnings, just contributions.) Put in $4,000, and you can take out $4,000 later - be it one day later, one week later, or one decade later. But some concerns were raised about the validity of that assumption, so I wanted to iron that out here using the IRA Bible, aka IRS Publication 590.
First, we head to the Roth IRA section, specifically the subsection called Are Distributions Taxable?. Here, the first sentence states:
You do not include in your gross income qualified distributions or distributions that are a return of your regular contributions from your Roth IRA(s)
Sounds pretty clear, but let’s keep delving in to clarify this point. The next section talks about qualified distributions, like those made after you turn 59½, which are definitely not taxable. We are given this decision flowchart (Figure 2-1), and… whoops, we don’t even pass the first box. Taking out your contribution within the first 5 years is not a qualified withdrawal.
Busted? Not quite. Not all unqualified withdrawals are taxable. Going to How Do You Figure the Taxable Part?, we are directed to Worksheet 2-3, titled “Figuring the Taxable Part of a Distribution (Other Than a Qualified Distribution) From a Roth IRA”. This worksheet is totally confusing, but if you run through it, you will see that in the end you subtract out line 12 - “the total of all your contributions to all of your Roth IRAs”. So, although it is an unqualified distribution, taking out your contributions is not taxable.
What about the 10% penalty? Couldn’t that be separate? In the section on the penalties Additional Tax on Early Distributions, we see this:
Unless one of the exceptions listed below applies, you must pay the 10% additional tax on the taxable part of any distributions that are not qualified distributions.
Since this unqualified distribution is not taxable, there is no penalty to worry about. We are totally in the clear. Whew!
How Do I Make A Withdrawal?
If you are under 59½, you usually need to make a specific request to your broker. In addition, you’ll need to fill out IRS Form 8606 when tax time rolls around. Here is the info from my Vanguard account:
You can request a withdrawal from your IRA online, over the phone, or by mail. You can have a check sent to you, have the proceeds deposited directly to your bank account, or transferred to a nonretirement Vanguard account.
Find more in Investing, Retirement | 10/15/07, 11:14pm | Trackback
October 15th, 2007 at 11:54 pm
Want to know a really weird rule that’s similar to this? First of all, let’s call the sum of all contributions to a Roth IRA its “basis”. So, if you contributed $4k this year and last, you have $8k in basis. So, as you stated in this post, whatever it grows to in the future, you can take out $8k tax/penalty free.
What if you contribute to a Roth 401(k) plan (well, technically you are just making Roth contributions to a 401(k) plan, or putting money into a “designated Roth account”, but it’s easier to just talk about it as a “Roth 401(k) plan”, so I will refer to it as such)? You can’t take out a Roth 401(k) plan basis like you can with a Roth IRA. But, you CAN rollover your Roth 401(k) plan money into a Roth IRA. The question than arises, how much of your rollover is basis?
The answer? ALL of it! Whatever amount rolls over into the Roth IRA is now basis and can be taken out of the Roth IRA tax/penalty free.
So, let’s say you contribute $15k this year to a Roth 401(k) plan. Next year, you leave the job but keep your money in the plan. Over the next few years, it increases to $20k. If you really needed all $20k at that point, just roll it over to a Roth IRA and then empty it out. It’s all considered basis. If you left it in the IRA and it grows further to $25k, only the $20k that was rolled over is basis and can be distributed tax/penalty free.
This is why my Roth 401(k) plan money is staying in my former employer’s plan as long as possible (for now). I’m sure there may be other reasons to roll it over somewhere in the future (perhaps to a current employer’s Roth 401(k) plan)…
October 15th, 2007 at 11:59 pm
Very interesting point!
October 16th, 2007 at 1:04 am
Thanks guys, a great post and a great comment. I’m still contemplating between Roth and regular IRA tax treatment differences, but I definitely like the fact that you can take out the principal from Roth without penalties.
October 16th, 2007 at 3:00 am
first, only applies to contributions and not earnings. Just to make it clear if people are getting confused.
second, it is still a bad idea to mix monies for different purposes. Can you withdraw RIRA contributions at any time? Yes, but it doesn’t mean that you should use it as a primary vehicle for your emergency fund. It can be the next thing to look at when your emergency fund is depleted, but as a primary emergency fund, you are taking away from your retirement savings and taking away from the long term benefits of holding onto a RIRA. The purpose of having different monies for different purposes is just that, so you don’t take away from one goal/purpose to fund another. It’s part of diversifying.
October 16th, 2007 at 6:24 am
Jonathan,
Starting next year almost every company will offer roth 401k. Can you please provide detail that roth 401k is better or roth IRA(provided both has very good option , infect my company allows to access mutual fund window to go to vanguard funds).
First comment on this thread is very interesting.
October 16th, 2007 at 6:43 am
Jonathan,
Awesome post. I’m going to max the Roth IRA every year now. I wonder what the probability of the IRS changing this loophole is with the ever increasing popularity of Roth IRAs and 401(k)s? Sounds too good to be true, especially the rollover basis calculation outlined in the first post.
Good to know when some of us have questions about a topic you are willing to write about it and open it up for further discussion. One of the reasons I love your blog.
Thanks!
October 16th, 2007 at 7:01 am
@ Hoon Park -
Do you have evidence to back this up because I researched pretty hard before I rolled over my Roth 401k and everwhere I turned I was told that when it is rolled over they would separate the contributions and gains and so the new Roth IRA rollover would know what you originally contributed. Based on how the rollover went I believe that is the case as it was clearly defined what I had contributed on the rollover statement.
October 16th, 2007 at 7:06 am
I must say I’m behind on my Roth 401(k) readings. Looks like there is lots of potential confusion there as well… Have fun at IRS.gov
October 16th, 2007 at 8:48 am
What happens WHEN (note, not IF) you have your ROTH money aggressively invested for 30 years out, we hit a recession, the market tanks for a couple years, and your investments are down 40%?
Oh and because there is a recession, you just got laid off?
Oh snap. Now your $12,000 ROTH “emergency fund” just became $7,200 and you’ve got a $2,000 mortgage to pay and the kids need to eat. Better find a job in a recession real fast!
BE CAREFUL.
It sounds like you’re killing 2 birds with one stone by having your ROTH and emergency fund intertwined. But that only looks good in best case scenario.
You need to consider the WORST CASE scenario because that is the PURPOSE of an emergency fund. The PURPOSE of a ROTH Individual Retirement Account is totally different.
October 16th, 2007 at 9:22 am
There’s no reason that this investment has to be in anything aggressive. I’m thinking about pulling $ from my emergency fund to put into a TIPS fund within a Roth IRA. That will give me assurance of a return on my investment and provide a hedge against inflation.
I’m joining this school of thought that there is no reason not to have months 2-6+ of the emergency fund in a Roth IRA (assuming that one can’t fund both the $4K in the Roth and a separate emergency fund). Once I have my desired level of emergency savings in safe investments (within the Roth), I’ll start changing my Roth IRA contributions to a more aggressive investment.
Good discussion!
October 16th, 2007 at 9:24 am
Ted..
That’s a good point to keep in mind, but one can always keep a portion of his/her Roth IRA contributions in a less-risky money-market fund.
October 16th, 2007 at 9:49 am
Ted: why would you invest your emergency funds in an aggressive portfolio? This can be viewed as a loop hole. Why not take advantage?
On the one hand, if we have an emergency, we’ll have readily available funds to withdraw. On the other, if don’t have to withdraw, we have a pile of money to add to our retirement.
Seems like a win-win to me.
October 16th, 2007 at 10:19 am
Once you have taken a withdrawl from the Roth account, are you allowed to payback the amount taken out while not affecting the contribution limit? I would assume the answer to this is yes, otherwise it would not make sense to use a Roth IRA as an emergency account.
October 16th, 2007 at 10:21 am
Ted: first of all, i don’t think anyone here has said that you should replace an emergency fund Roth IRA (or Roth (401(k)), and second of all, if you were investing into Roth IRA for 30 years aggressively, you’d have a whole lot more than $12,000. With contributions maxed out at $4,000 a year, your contributions alone would be more than $120,000 and with compounded interest of 7% you’d have about $500,000 in your account.
October 16th, 2007 at 10:26 am
Yeah, there is no way that the IRS will allow an increase in basis simply due to rolling over from a Roth 401(k) to a Roth IRA. The funds in the Roth 401(k) would retain their tax attributes - contributions vs. appreciation - upon rollover. Upon making an unqualified withdrawal from a Roth account, you will be taxed pro-rata on the FMV:Contribution ratio. So, if your account is worth $20,000, your contributions were $16,000, and you withdraw $10,000, $2,000 of the $10,000 will be taxed [$10,000 - ($10,000 x $16,000/$20,000)]. The IRS does not allow you to allocate what you withdraw solely to contributions.
October 16th, 2007 at 12:26 pm
It seems to me the biggest drawback of using your IRA as an emergency fund is that if you have to withdraw your money you can’t put that contribution back in. Or am I wrong about that?
October 16th, 2007 at 12:42 pm
Creative -
I’m not talking about 30 years from now and I think you know that. Say some implements this today. They fully fund a Roth aggressively with a 30 year horizon. Say they get 30% total growth in years 1 and 2. Everything’s going great and they again fund a Roth in year 3.
Something causes a recession. Account drops 20% in year 3. Recession continues in year 2. Down 20%. Your $12,000 emergency fund is now worth ~$9,200.
This is precisely the time when the emergency is most likely to happen: When things go bad. That’s why its called “emergency fund”. Note that not only have you now lost principal to your EF, but you can’t go back and put the money back into the ROTH account! Once its out, its out (this is a real emergency, not a temporary holdover).
On the other hand, say you put your $4k Roth into a safe money market or ST treasury bond fund. Are you really win-winning as TallWes says? At the end of 3 years you’ve got $12k in a Roth Account for an emergency fund. In a taxable account you’ve got $12,450 available in the emergency fund after taxes.
Oh, but you say I got $600 more dollars invested for retirement that can be invested aggressively and that will grow to several thousand over 30 years! And I say if you can’t save $200 dollars a year in an IRA without playing this game, you’ve got bigger problems.
I’m not saying this isn’t a neat trick to the tax code. It is and could maybe provide some benefit to some. HOWEVER it ain’t all that great — unless you get really lucky. And it could be a disaster if you get really unlucky. If you know whether the roulette wheel at Caesar’s Palace is going to hit red or black this Friday at 7:07 pm, please tell me now.
October 16th, 2007 at 12:48 pm
Ted - Sorry if I misunderstood what you meant, I just took it literally when you said “money aggressively invested for 30 years out”. Either way, you’re probably right about keeping retirement money separately from the emergency fund unless you have absolutely no other choice and need to deplete all your accounts.
October 16th, 2007 at 1:01 pm
That should be year 4 not 2 in the second paragraph.
And Creative, yes, Jonathan has suggested funding a Roth before an EF.
BE CAREFUL is all I’m saying. If Jonathan can present the best case (he used 8% growth in his assumptions - which is what you use for stocks), he should do his duty and present the worst case other than the tiny caveat at the end of the first post.
Second putting the money in a money market does not significantly increase your wealth long term. Who’s retirement asset allocation includes a significant amount in a money market fund? Please post below if yours does.
If you include your bond allocation in your Roth, that creates two issues. First, if the emergency occurs you now need to sell stocks in your other accounts to rebalance your portfolio. It may be a bad time to do this. That’s risky. Second, professionals generally recommend you put your highest risk, least tax efficient investments in a Roth because of future tax advantages.
The most significant benefit I can think of is that this can create a temporary holding account for people who’s income is going to surpass the Roth contribution limits in the next few years. (Like Jonathan, surprise, surprise!) The only problem with this that people in this category already make enough have a Roth and EF! So again I say, this really doesn’t make much difference to regular people unless they want to gamble.
October 16th, 2007 at 1:10 pm
If you’ll refer back to the original post, please note that I am only advocating using Roth IRA as an Emergency Fund when it’s an either-or proposition between funding Roth or funding the Emerg Fund. Why not have some chance at tax-shelteredness, instead of no chance?
October 16th, 2007 at 1:18 pm
@ Hoon Park -
Your ideas about rolling the Roth 401 to a Roth IRA, thereby getting a favorable basis would be great if it were true! However, that’s not how US tax code is constructed and it certainly isn’t going to work according to situation you described above — nice try, though.
Although i haven’t looked at the specific tax code relating to Roth 401 rollovers to Roth IRAs, i can tell you that you’ll be faced with one of two scenarios, and it’s likely that ONLY ONE OF THEM MAY BE CORRECT.
Scenario 1: When you rollover your Roth 401 to the Roth IRA, the basis for your Roth 401 (the fair value your qualifying contributions at the time they’re made) will become the basis of your Roth IRA. So any gains from the Roth 401 do not affect the basis on conversion.
or,
Scenario 2: Whey you rollover your Roth 401 to your Roth IRA, you pay one-time tax on the gain of your 401, and the rolled over amount then becomes the new basis of your Roth IRA.
I suspect that Scenario 1 is the accurate way to account for Roth 401 rollovers to Roth IRAs, but i could be wrong (consult your tax advisor before making the wrong move!) However, i’m certain that you will not receive the favorable tax benefit of the increased basis of your Roth without some consequences in the form of a tax on the gain or penalty on a non-qualified rollover, or both.
One of the things that makes Jonathan’s blogs so great is that goes the extra step to make sure he doesn’t provide incorrect information. Thanks!
October 16th, 2007 at 3:58 pm
Jonathan,
Are u still allowed to contribute to the roth because ur income’s are now above the limit?
October 16th, 2007 at 4:41 pm
Quick question, if you take that money out, are you allowed to put all of it back in later? Or do they hold you to the $4000 a year still? If you can put it back in, how long do you have until that time runs out?
October 16th, 2007 at 5:42 pm
I am personally going to be unable to contribute to a Roth IRA this year. I am currently investigating whether I should contribute to a non-deductible Traditional IRA.
–
From Pub 590:
October 16th, 2007 at 7:47 pm
well these recent posts have been very helpful as i am just making my elections for benefits @ my first job out of college. i have fully funded a roth ira @ vanguard for the past couple years and as of now dont have a roth 401(k) available to me. once i decide on my contribution percentage and investment choices (plan is through fidelity), i will contribute as i would if i was getting the 6% company match (not eligible until next year).
while i understand how amazing roth ira’s are (and hope they dont get legislated away), i’m just not understanding where i should be putting savings for a house/etc at this point. as a 22 year old, putting down 20% on my first home/condo or real estate in (hopefully) 5-8 years is the most obvious medium term goal. while its great to have the tax free growth & withdrawals in a roth, its only $4k a year (yes i know it increases next year and i plan to fully fund it every year…). i just dont understand where to starting putting the other money beyond the future company match.
i am still budgeting all of my finances and figuring out what my percentages are (required expenses vs discretionary spending vs savings %), so i’m still playing around with it all (and probably should be doing some more reading… esp considering i now have to track asset allocation @ different brokerages… blah). i’m not sure if i should be opening a taxable brokerage account or what…. i dont want to dump some ridiculous percentage of my income now into my 401(k) and not be able to really get at it in the future…. my expenses will also be rising a good amount next year, so i dont want to spread myself too thin.
thoughts or advice would be appreciated
October 16th, 2007 at 7:53 pm
I don’t think entwining your retirement account with your emergency fund is a good idea, for psychological reasons. It’s too easy to backslide on your savings plan if in your mind your retirement account isn’t sacrosanct, it’s best to fund it and then leave it alone. Perhaps you and a few other Americans don’t need to compartmentalize your savings and retirement separately but I think you are in the minority, and the numbers that reflect the lack of savings and amount of personal debt that most Americans have seems to bear this out.
I know that I need to have very strong boundaries around my savings and debt reduction, otherwise I’ll slip back into the woolly financial thinking that got me into debt in the first place. If I were to plan that my emergency fund was a withdrawal from my Roth IRA then it’s quite possible I would have no money left in retirement (or at least not nearly as much as I planned for.) I just don’t have the discipline for it and I would argue that the majority of Americans probably don’t as well given the spending and debt habits that we see.
Transformation of spending and savings habits for most people needs to be as rigorously treated as overcoming addiction. You need to quit cold turkey and transform the underlying behavior. Just as an alcoholic can never in their life have another drink or they will backslide, most people coming out of a lifestyle of spending more than they earn and living with a mountain of debt can never again live without rigid financial boundaries.
October 16th, 2007 at 8:13 pm
If you contribute to a non-deductible IRA, you will be able to convert it to a Roth in 2010, when the income limitation on conversion is lifted. The tax you would incur on the conversion (the tax on the appreciation of the non-deductible IRA) can be spread over two years. If you choose not to convert, then when you reach 59-1/2 and start drawing on it, you will be taxed pro-rata on the proportion of the FMV to basis.
October 16th, 2007 at 11:49 pm
If you’re debating between a tradition IRA and a Roth IRA, there is a magic number at which any additional contribution does not reduce your taxable income. For me last year, it was $1720. So $1720 went into the Traditional, and the balance of $4000 went into a Roth.
October 17th, 2007 at 3:37 am
I have a question about the limitation to making contributions. The IRS site you referenced notes that there is a 6% excise tax when people put excess funds into their ROTH IRA but does not suggest that these funds must be withdrawn. I’m only 24 years old, but am presently a student with loans as my only income, but stock holdings and some savings. If it is merely a 6% tax that I must pay in order to put some savings in my IRA it would make sense for me to do so in the long run. Is this legal or or am I misreading IRS Publication 590?
October 18th, 2007 at 4:30 am
LargeTalons and Ashley: once you withdraw from a Roth you can never, ever replenish that amount. This is why withdrawing from a retirement vehicle before retirement is just a bad idea. Presumably you are investing wisely and your Roth is part of your retirement portfolio. As such, if you withdraw, you can no longer count on it for retirement.
Aksays: a little off. in 2010 you will be able to directly rollover a 401k into a roth. You can convert from a TIRA to RIRA at any time so long as you meet the AGI limitations. You also have to take tax into account as you will then have to pay tax on the converted amount. Currently, you can rollover a 401k into TIRA then convert TIRA into RIRA. 2010, the extra step won’t be necessary.
Johnathan: I don’t think it has be an either or scenario. You can fund both an emergency fund and a RIRA, if you only have $4k, albeit you will not max your RIRA. However, you will have a buffer in the form of an emergency fund that will not take away from your retirement savings plan.
Again, mixing monies for different purposes is just a bad idea, because you can no longer count on your savings plan for each goal. Of course you can adjust, but in the case of RIRA, you will never be able to make up for what you have withdrawn.
October 18th, 2007 at 7:14 am
Tim:
If one does this, one must not think of these funds as Retirement funds. This is an emergency fund (EF) that just happens to have the word Retirement in the name of the account. In the end, once you turn 65, voila, you magically have added a pile of retirement income to your portfolio that can be used for living expenses.
On the flip side, for example, let’s say you just have a plain old EF in a bank right now. Furthermore you don’t have any emergencies. Fastforward, to when you’re 65 and retired. You have a pile of cash that was your EF. That is now spending money for living expenses. That little pile could have been much bigger if it was in a ROTH account.
-Wes
October 18th, 2007 at 8:38 am
Tim:
My response was to Jonathan’s decision whether or not to contribute to a non-deductible IRA. Assuming his AGI prevents him from contributing to a Roth, the same would hold true on rolling over to a Roth - except in 2010 when the AGI limitation on conversions will be lifted.
The Heroes Earned Retirement Opportunities Act was a gift to high income individuals who would not otherwise be able to contribute or convert to a Roth. I would advise contributing to a non-deductible and then converting in 2010 when he is able, especially since he can spread the tax on the FMV in excess of basis over two years.
October 20th, 2007 at 9:57 pm
I’m really late to the table. But I just wanted to say I follow this. I guess the caveat here is keep up with ever-changing tax law. Even as a tax practicing CPA it is easier said than done.
But I am quite conservative and tend to err on putting too much in my IRAs and less in cash. I know I have a really hefty emergency fund to fall back on in this case - with all the retirement tax benefits if I never need to touch it. (When you look at the odds in either case it is a start move. The odds I’ll need more than my cash emergency fund? Slim).
But when I mention this to fellow financially responsible people they flip out. So thank you for your post. I think you have to have a certain mindset. Since hell would have to freeze over before I touched my cash emergency fund and sell my more liquid assets, I know odds are slim I would ever pull money out of my IRA. But being rather conservative it is the only way I can fork all that money to my IRA that I wish I had in cash or investments for a rainy day.
The other key is we contribute like 25% to retirement which is really way more than we need. If we were only contributing 10% this would be dangerous ground. On the flip side, when you are young with many competing money goals, you can kill 2 birds with one stone putting your money in a ROTH and having it as an emergency fund as well. It probably beats the alternatives (like consumer debt).
I am not sure how I would feel if I was in a higher tax bracket. But since our tax bracket is nil, it makes much sense to funnel as much as we can into our ROTHs, for now.
I think Tallwes said much the same point very well.
October 23rd, 2007 at 3:02 pm
From the flowchart: Was the distribution made to your beneficiary or your estate after your death?
Kinda hard to answer when you’re dead x-/
October 23rd, 2007 at 3:37 pm
@ Ken - The 6% pertains to contributions over the QUALIFIED amount. Only qualifying contributions receive favorable tax treatment — ie, no taxes on qualified withdrawals. You cannot make a qualified withdrawal of an non-qualifying contribution.
Additionally, loan proceeds are NOT income, and you can only make QUALIFYING Roth contributions to the extent you (or your spouse) has income, which means - no income, no contribution. Furthermore, i hope you weren’t considering contributing your loan proceeds anyway — that’s definitely a violation of your loan terms (not that students pay much attention to limitations of their loan proceeds) and it flies in the face of sound investing.
October 24th, 2007 at 1:03 am
Just as a followup point to Jonathan, if forced to decide between a roth verses a taxable emergency fund we should also remember there are likely to be other alternatives available like credit cards offering 0% apr for 12/15 months that one could draw upon if in a jam without having to liquidate the roth. There are no loans/promotions for retirement.
October 27th, 2007 at 8:17 am
So if I overcontributed to Roth in the beginning of the finacial year (due to unexpected raise or bonus) is it possible to get the principle contribution decrease without penalties? What happens to interests?
May 2nd, 2008 at 10:57 am
Hi, very interesting. I just talked to Vanguard, there is indeed no penalty for withdrawing one’s contributions. What is interesting, and I need some backup here, is he said that, if one were to contribute the max $5000, then withdraw say $2000, he CAN re-contribute that $2000 back, but it has to be within a 60 day window. He called this an “indirect rollover”. Thoughts? Thanks, great forum-Dan
May 2nd, 2008 at 4:00 pm
dan - Yes, that is technically true. Be sure to keep good records and don’t go past the 60-day window, however.
June 24th, 2008 at 7:21 am
Can you withdraw from an IRA and if so how frequent and is the money taxable if you are over 591/2?
June 28th, 2008 at 1:35 pm
Hi, in regards to dan’s post, what if you didn’t make any contributions for this year (2008) yet, and you decided to withdraw $6000 from a Roth IRA with a $12,000 basis. Would you be able to re-contribute that $6000 back within a 60-day window?
June 29th, 2008 at 7:26 am
hmmm, that’s a good one. Jonathan? Personally I don’t see why not