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  • Writer's pictureNate Baim, MBA, CFP®

A Tool to Increase Your Plan’s Resilience

A Tool to Increase Your Financial Plan's Resilience Graphic

For early and mid-career professionals, having flexibility in your financial life is essential. Being younger and more years to retirement means you have many unknowns in the future, which can be hard to plan. Maybe you want to start a business, pay for your children's education further down the road, or want to retire earlier than age 65. Understanding the features of the tools at your disposal to navigate your financial life is essential. And the Roth IRA is one tool that can add resilience to your financial plan. Furthermore, the Roth IRA can provide Gen Z, Millennials, and Gen X some flexibility in their economic lives if used properly.

The advantage of the Roth IRA is that you pay the taxes before you contribute, so your money grows tax-free, and no taxes are due on withdrawals. The problem is that the account is regarded as a retirement account, so there is generally a 10% penalty for early withdrawals before age 59 ½. Furthermore, unlike Traditional IRAs, Roth IRAs do not have a required minimum distribution (RMD) once you reach age 72. The lack of any RMD associated with the Roth IRA gives you more flexibility and options when managing your taxes during retirement.

Be mindful that you must qualify to make contributions to a Roth IRA. If your modified adjusted gross income precludes you from making a direct Roth IRA contribution, consider the Backdoor Roth IRA strategy.

However, there are some situations where you can withdraw funds before the minimum age without paying the penalty. Understanding the rules can come in handy if you need cash to buy a first home, pay for college, or if your family grows.

Ground Rules to Consider

Before we explore the exemptions, let's consider the ground rules, which include:

  • The Five-Year Rule

  • The Minimum Age Limit

  • Inherited Roth IRA

The Five-Year Rule

Roth IRAs have a layer of complexity when it comes to taxes. The account has a five-year holding requirement that applies to earnings on your contributions. Your original contributions are made with after-tax dollars, so no taxes are due on contributions. But if the assets grow inside the Roth, any growth will be subject to taxation if the account is less than five years old.

The Minimum Age Limit

If you want to withdraw funds before age 59 ½, you'll have to pay a 10% penalty for early withdrawal unless you meet exemption criteria. If you've owned the account for less than five years, you will also be liable for taxes on the earnings on the money you withdraw. You don't have to pay taxes on the original contribution you withdraw because you funded the account with after-tax dollars.

Inherited Roth IRA

The SECURE Act, signed into law in 2019, made changes to how beneficiaries manage inherited IRAs. Surviving spouses and minor children, beneficiaries who are not more than ten years younger than the deceased, and children who are chronically or disabled do not have limits on the amount of time to withdraw the funds. Anyone else inheriting a Roth IRA must distribute all the assets in the account within ten years of the original owner's death.

The rules here are pretty complicated, and there are strategies to follow depending on your age, the age of the account, your relationship to the original owner, and your tax situation. Your unique situation and goals will determine the best course of action when managing an inherited IRA.

Roth IRA Penalty Exemptions

The situations which allow you to avoid the early withdrawal penalty include:

  • Over Age 59 1/2

  • Medical or Healthcare Costs while Unemployed

  • First Time Home Purchase

  • Qualified Education Expenses

  • Birth or Adoption

Over Age 59 1/2

You can avoid the 10% penalty if you are over 59 1/2. If you haven't met the five-year rule, you'll still owe taxes on earnings. If you are under age 59 1/2 and don't qualify for a particular purpose, you will owe a penalty.

Medical or Healthcare Costs while Unemployed

If you become unemployed, you can access funds to pay for unreimbursed medical expenses or health insurance premiums.

Home Purchase Exemptions

If you're buying your first home or you haven't owned a home as your primary residence in the last two years, you don't need to pay the penalty if you withdraw earnings for the purchase. You don't have to be the buyer – it can also be a spouse or a family member, and you can remove the funds from your account. It's not just for home purchases – the IRS regulations state "buy, build or rebuild." You can also use the money for costs related to the acquisition, like closing costs. There's a $10,000 lifetime limit on waiving the penalty on earnings for this exemption.

Education Expenses

Qualified education expenses also avoid the penalty, and can be for you, a spouse, or your children. The range here is pretty broad – qualified higher education expenses include tuition, fees, books, supplies, and equipment required for enrollment. Room and board are also covered for students who are enrolled at least half-time.

Using the Roth IRA to fund education expenses can be a great tool to provide flexibility. With the 529 plan, you must use the funds for qualified education expenses to avoid taxes and penalties. With the Roth IRA, you can use it for eligible education costs or retirement. This element of the Roth IRA provides greater flexibility and is a great value add for savers.

Birth or Adoption

If you've just had a baby or adopted, you can withdraw up to $5,000 from a Roth IRA without the 10% penalty. Each parent can use the $5,000 exemption for a total of $10,000 penalty-free.

Permanent Disability

Suppose you become permanently disabled as defined by the Social Security Administration (which is a high bar to cross). In that case, the IRS waives the 10% penalty for early withdrawals before age 59 ½. The Social Security Administration states you must not be able to engage in any substantial gainful activity due to a physical or mental impairment that is either expected to result in death or will last for at least 12 months to be considered disabled.

An Alternative to Consider

Savers often overlook the taxable account. But where the taxable account lacks tax efficiency, it provides flexibility. You may save in various investments with a taxable account. And with a taxable account, you don't have the pesky penalty rules to navigate as you find with IRAs or other popular retirement accounts (like 401ks, 403bs, etc.).

The Takeaway

Because Roth IRAs allow money to grow tax-free and withdrawals that meet the five-year rule and the age requirement are tax-free, they are a precious retirement asset for early and mid-career professionals. They can provide income flexibility and help reduce your taxable income in retirement, allowing you to manage costs better.

But sometimes, withdrawing from your Roth IRA makes sense. Remember that even if you can avoid the penalty, you may still have to pay taxes on earnings. Before withdrawing from a Roth, even if you qualify for an exception to the 10% penalty, consider your entire financial situation and weigh other options.

Talking with a planner can help determine if a Roth IRA makes sense for your situation and provide alternative solutions that may better align with your goals and financial plan. Working with a trusted financial planner can reduce your stress and help you map out the best course of action for your situation. At Pursuit Planning and Investments, LLC, I help you think through your options. I help you make the best decisions for yourself, your family, and your money. Feel free to place a commitment-free 30-minute meeting on my calendar. We can discuss your goals and begin best optimizing your financial plan in that meeting.

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