The federal government created Roth IRAs to help you save for retirement. Though you can dissolve your Roth IRA at any time, doing so before you can take qualified distributions has significant tax implications. If you do have to dissolve your Roth IRA, knowing the tax consequences and ways to avoid the early withdrawal penalties helps prevent you from being blindsided come tax time.
Qualified or Non-Qualified
The tax consequences of dissolving a Roth IRA depend on whether the withdrawals taken to liquidate the account meet the criteria for qualified distributions. To take a qualified distribution, you must satisfy a two-prong test. First, your Roth IRA must be at least five tax years old. Next, you must be 59 1/2 or permanently disabled. You can also satisfy the second test for up to $10,000 if you are using the money to buy your first home. Failure to meet either of these tests results in the dissolution being treated as non-qualified.
Qualified distributions from a Roth IRA come out 100 percent tax-free, including all of your contributions and earnings, according to IRS Publication 590. However, you still have to tell the IRS what you did on your tax return by reporting the amount of the distribution as a nontaxable IRA distribution. Though this sounds great, dissolving your Roth IRA ends the tax-sheltered growth of the funds in the account. Therefore, any future earnings on the money become taxable income.
When you make a non-qualified dissolution of the Roth IRA, you get your contributions out tax-free because you received no tax deduction for putting in the money. However, any earnings taken out count as taxable income. On top of that, the earnings are subject to a 10 percent additional penalty tax because they are taken out as a non-qualified distribution. For example, if you fall in the 33 percent tax bracket, 43 percent of your earnings would go to paying income taxes and the 10 percent penalty.
In some cases, you can avoid the penalty on non-qualified distributions from a Roth IRA. Examples include if you have medical expenses exceeding a specified percentage of your adjusted gross income, you are 59 1/2 or older, you are paying for qualified higher education expenses, you are paying for medical insurance premiums after becoming unemployed or using up to $10,000 for the purchase of a first home. You can use multiple exceptions if more than one applies. However, if you do qualify, you cannot avoid the income taxes.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."