A Roth IRA is an IRS-approved retirement account that lets you tuck away money for the future up to an annual maximum. If you have a Roth plan, and you later decide to cancel or close it, understanding the potential tax implications can help keep money in your pocket.
Roth IRA Rules
When you squirrel money away in a Roth IRA, you don't get a tax deduction for your contribution like you do with a traditional IRA. However, you get something even better. All of the income that accumulates in the plan doesn't get taxed at all when you withdraw it in retirement.
The catch is that you have to be 59 1/2 years old or older to enjoy this tax benefit. If you withdraw funds before then, you will not only be taxed on any income portion of the withdrawal, but you will also pay a 10-percent penalty on it. That makes it very important to consider all of the consequences of withdrawing early and closing your Roth IRA before you do it.
Withdrawal Ordering Rules
If you're closing your Roth IRA, you first have to take the accumulated funds out of it. You can do that in one lump sum or make multiple withdrawals. Both have the same tax consequences. If you're 59 1/2 or older, you can take it all out without taxes or penalties. If you're younger than that, Uncle Sam requires that you apply IRS-mandated ordering rules to each and every withdrawal.
First, contributions must be withdrawn, then conversion funds if you've ever rolled money in from another plan, and then income. Your plan administrator will issue you statements at least annually so that you can track your total contributions. As long as your cumulative withdrawals are less than what you originally put into the plan, you can do that tax- and penalty-free.
Once you start dipping into the income, though, you will have to report it on your tax return, and calculate the 10 percent penalty. If the additional taxable income will put you into a higher tax bracket, and it's close to the end of the year, consider withdrawing part of the income in December of one year and the rest in January of the next to save on taxes. Once the account is empty, the plan administrator will give you forms to fill out to close the account.
Roth IRA Rollover Rules
If you want to cancel your Roth IRA with one plan administrator and move your funds to a different Roth plan, you can do that by making a direct plan-to-plan transfer. Once the new Roth plan is open, contact the plan administrator of the old one to initiate the transfer. The money will be shuttled from one plan to the other without you ever touching it. This preserves its tax status and there will be no taxes or penalties to deal with at the end of the year.
Alternatively, if you only need short-term funds from your plan, you can withdraw both contributions and income, as long as you put them back within 60 days. The plan has to have been open for at least five years, and, if you miss the 60-day deadline, you won't be able to put it back in and will be assessed taxes and penalties on the income portion.
Exceptions to the Rule
The IRS allows you to take money out of your Roth or traditional IRA without tax consequences in certain situations. If you are buying your first home, you can withdraw up to $10,000 in your lifetime. You can also use your IRA funds to pay for educational expenses, medical expenses over 7.5 percent of your adjusted gross income, or if you need to pay health care premiums for your family, if you have been unemployed for 12 weeks or more. If you have a disability, you can also tap the fund.
Angie Mohr is a syndicated finance columnist who has been writing professionally since 1987. She is the author of the bestselling "Numbers 101 for Small Business" books and "Piggy Banks to Paychecks: Helping Kids Understand the Value of a Dollar." She is a chartered accountant, certified management accountant and certified public accountant with a Bachelor of Arts in economics from Wilfrid Laurier University.