Special Tax Planning Supplement: Roth IRA Withdrawals

Written By: Attiyya S. Ingram

For the majority of clients who meet certain income criteria, a Roth IRA has been their preferred way to save for retirement. Unlike a traditional IRA or 401(k), the Roth IRA allows for the growth of compound interest that will never be taxed. It is this feature, the growth of tax free earnings, which makes the Roth IRA so alluring. However, for households struggling to fund emergency, college, and retirement savings, it can be a means of flexibly saving for multiple financial goals in one place.

The Roth IRA is comprised of two parts— after-tax contributions, money placed into the account with post taxed dollars, and earnings, the compound interest received over time. While withdrawing contributions never generates tax liability, the earnings portion cannot be accessed by the taxpayer prior to age 59 ½ without having to pay interest at the marginal tax rate plus a 10 percent penalty. There are very limited exceptions to this general rule. The Internal Revenue Service (IRS) Publication 590 explains the exceptions and should be reviewed to gain a thorough understanding of the rules applying to exceptions.

While many clients diligently make regular contributions to their Roth IRA, the thought of making premature withdrawals in the future is seldom on their minds. For this reason, many do not keep track of their total contributions over time. Others are not such diligent contributors, stopping and starting with no regularity whatsoever and have no sense of how much they have contributed.

Even though a return of contributions is never taxable, if it’s not reported correctly, the IRS will treat it as a non-qualified distribution of earnings resulting in tax liability. Clients assume that because they withdrew their contributions, no taxable event has occurred and no reporting is necessary. This sentiment is bolstered by the absence of a determined taxable amount on the 1099-R.

As a tax professional, I frequently see new clients who have received an alarming IRS notice declaring taxes are owed as a result of a Roth IRA non-qualified distribution and the client is unsure how to proceed. If a distribution of contributions from a Roth IRA is taken, a Form 1099-R will be issued by the institution that administers the account no later than January 31st of the following year. Box 1 of the 1099-R will show the total amount received, and the taxable amount will not be determined anywhere on the 1099-R, as financial institutions are not required to report it. That responsibility lies with the taxpayer.

An early withdrawal from a retirement account should rarely be considered for non-emergency purposes and should be a last course of action when emergency funds are needed. For this reason, the emergency funds in the Roth IRA might be considered part of a client’s deep emergency fund reserve, and relatively smaller emergencies could be addressed by making changes to budgeting and spending plans.

Educating younger clients on why a Roth IRA may be a great retirement savings option for them can be difficult when retirement seems so far away. Some are reluctant to place their money in an account that is inaccessible until they reach retirement age. Many clients may opt for the Roth IRA because it can perform double duty. Knowing they can withdraw their contributions tax-free and penaltyfree at any time, if absolutely needed, may induce them to start saving in a Roth IRA today. It may be less overwhelming to save in one account, rather than trying to establish college savings, retirement savings and emergency savings in several accounts that may be with various financial institutions. While early withdrawal should be a last resort, different approaches work with different clients.

Encouraging and helping clients to become familiar with and effectively manage their Roth IRA account statements, whether paper or electronic, can be quite helpful in the event that an unplanned withdrawal becomes necessary. It is crucial that if a distribution of any kind is taken, even if it is merely a return of contributions, it is correctly reported to the IRS.

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