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Overview
In most retirement plans like traditional IRAs, all funds must remain in the account until the owner reaches a specified age, usually 59 1/2. However, in a Roth IRA some funds may be withdrawn early, while others may not (with a few exceptions). The IRS has established a set of "ordering rules" to determine if a withdrawal of funds is allowed without penalty. Roth ordering rules state that if funds are withdrawn, they are considered contributions. If the total that has been contributed is exceeded, the withdrawn funds are designated as coming from funds rolled over into the account. If that amount is also exceeded, all remaining funds withdrawn are earnings.
Contributions
Unlike most retirement plans, there is no up-front tax deduction for a Roth IRA. Instead, earnings withdrawn after the account has been in existence for 5 years are tax-free provided the owner is past age 59 1/2. Contributions can be up to $5000 per year and $6000 if you are older than 50, and may be withdrawn at any time. Roth ordering rules define all withdrawals as contributed funds as long as the total withdrawn is less than what has been contributed.
Rollovers
You can convert ("roll over") funds from a traditional IRA or 401(k) plan subject to IRS restrictions. Funds rolled over into a Roth IRA must remain in the account for at least 5 years. When funds are withdrawn early, they are considered to be part of rollover funds only if the amount withdrawn is in excess of the total contributions made to the Roth IRA.
Earnings
Funds in excess of the total of contributions and rollovers are defined as earnings. They may not be withdrawn early without being subject to a 10 percent penalty. In addition, earnings withdrawn early may forfeit their tax-free status, making this a very expensive violation of IRS rules. The important thing to remember is that withdrawals are considered earnings only after an amount equal to all contributed and rolled over money has been withdrawn.
Exceptions
The IRS allows three exceptions to the Roth ordering rules for early withdrawals. You may take out funds in excess of contributions if you are disable,d or for the purchase or rebuilding of a first home (up to a total of $10,000). A beneficiary who inherits a Roth IRA can also take a complete distribution of funds without penalty, although regular taxes may apply.
Warning
Investors should be cautious when choosing investments or rolling over funds into a Roth IRA. Certain investments, such as collectibles like rare coins and antiques, are not allowed. The IRS treats such an investment as a premature disbursement. The same is true of a "failed rollover," one that is not carried out in compliance with IRS regulations. In some cases Roth ordering rules may not apply to these situations, so check with your financial adviser beforehand.
