If you need cash for a personal expense such as a child’s wedding, you may have more tax-smart options at your disposal than you think.
Strategy: Consider withdrawing funds from a Roth IRA. Despite a common perception, nonqualified distributions from a Roth for personal expenses like weddings aren’t fully taxable.
In fact, depending on your situation, nonqualified distributions might even be completely tax free!
But remember that Roth IRAs are meant for retirement saving. Use this technique judiciously.
Here’s the whole story: Qualified Roth IRA distributions are 100% exempt from federal income tax (and usually state income tax, too). For this purpose, a qualified distribution is one from a Roth in existence at least five years that is made after reaching age 59½, due to death or disability or used to pay first-time homebuyer expenses (up to a lifetime limit of $10,000 for the latter). All other distributions are nonqualified, but the tax results from receiving nonqualified distributions are determined under special “ordering rules.”
How it works: Funds are treated as coming from Roth IRA assets in the following order.
1. Regular annual Roth contributions. These can be taken out tax free even if they are nonqualified.
2. Contributions from converting taxable traditional IRA balances into Roth status (i.e., “taxable conversion contributions”). These can be taken out tax free even if they are nonqualified, but a 10% penalty tax generally applies to withdrawals within five years of the conversion, unless you’re age 59½ or older.
3. Contributions from converting nontaxable traditional IRA balances into Roth IRA status (i.e., “nontaxable conversion contributions”). These can be taken out tax free even if they are nonqualified.
4. Earnings that accumulated within the Roth IRA. These amounts are taxable when withdrawn unless they met the definition of qualified distributions. In addition, a 10% penalty tax may apply to withdrawals before age 59½.
In other words, if you don’t reach the point where you’re withdrawing Roth IRA earnings, you generally will have little or no income tax to pay on your withdrawals. For example, if you need another $20,000 for a wedding and you’ve contributed $25,000 to your Roth over the years, the tax on the $20,000 withdrawal is zero.
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