Contributing money to retirement plans with tax benefits is one of the best ways to build wealth for retirement, but the government imposes strict regulations on tax-advantaged accounts. Retirement accounts that offer tax deductible contributions, like 401(k) plans and traditional individual retirement accounts, require account holders to pay taxes on distributions. Roth IRAs offer the benefit of tax-free withdrawals, but not all Roth IRA distributions avoid taxation.
Roth IRA Basics
Individual retirement accounts come in two basic flavors: traditional IRAs and Roth IRAs. Individuals can contribute up to $5,000 to either type of IRA each year; people aged 50 or older can contribute $6,000. Roth IRA contributions are not tax deductible like traditional IRA contributions: You must feed Roth IRAs with after-tax income. On the other hand, Roth IRA contributions can be withdrawn at any time tax-free, and withdrawals of investment gains aren't taxable as long as they are considered "qualified distributions."
Roth IRA distributions must meet several guidelines set by the Internal Revenue Service to be considered qualified distributions and avoid taxation. According to the IRS, a distribution must be made after the five-year period that starts the first year you contribute to a Roth IRA to be qualified. In addition, a qualified distribution generally must be made after you reach the age of 59 1/2. The age requirement may be waived if you are disabled or making a distribution of $10,000 or less to buy or build a first home.
Roth IRA withdrawals made before the age of 59 1/2 are considered early distributions. If you make an early distribution, you must pay taxes on any investment gains you withdraw. In addition, the taxable portion of the withdrawal is subject to a 10 percent early-withdrawal tax penalty. Early withdrawal penalties give investors extra incentive to keep money in accounts until retirement age.
You may be exempt from the early withdrawal penalty on Roth IRAs in certain situations. If you make an early withdrawal because you are disabled, the beneficiary of a deceased IRA owner, paying medical insurance premiums after losing a job or subject to an IRS levy, you may be exempt from the penalty. High medical expenses and higher education expenses can also be grounds for an exception to the penalty.