A Roth IRA Refresher

Surprisingly, Congress was generous when creating this rule. A contribution made for a specific tax year is considered to be made as of Jan. 1 of that year. Also, this test only needs to be met once, so if I contributed one dollar to my IRA five years ago, the requirement has been met for all future contributions. That's why it's so important to contribute, no matter how small, as early as you can to get that five-year clock ticking.

2. Other Ways No Fun

There are only a handful of other ways to receive earnings tax-free, and most of them aren't fun, which would include death or disability. The death exception obviously doesn't apply to the account owner, but rather the beneficiaries, or the people inheriting the account. The other is for a first-time home purchase and is limited to $10,000.

Any other withdrawal will be a non-qualifying distribution. Typically, this will result in ordinary income tax plus an additional 10% penalty. Of course, there are a handful of exceptions to this, including higher education expenses, deductible medical expenses, and an IRS defined term of "substantially equal periodic payments" to name a few. It's important to note, while these exceptions will waive the 10% penalty, any amount that is considered earnings will still be subject to income tax.

3. Roth Flexibility

The operative word there is "earnings," which bring us to an often-misunderstood rule of the Roth IRA. The contributions that have been made to a Roth IRA over time can always be withdrawn at any time for any reason with no tax and no penalty.

Consider this example: Megan is currently age 48. Over her lifetime she has contributed $50,000 to her Roth IRA. The account over that time has grown to $90,000. One Friday, she decides that she wants to take a $50,000 withdrawal and fly to Las Vegas and test her luck. She can do so from her Roth IRA and have no tax consequences. The next dollar withdrawn however would be subject to tax and penalty unless one of the exceptions outlined above apply.

While Megan's idea may sound like a lot of fun, it obviously isn't smart from a financial planning perspective. But it does highlight the amount of flexibility a Roth IRA provides. When used in conjunction with a sound retirement strategy, it can be one of the most powerful savings vehicles available.

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Jeremy Hus, MSFS, CFP, ChFC, CASL, CLU,  is vice president of financial planning at Barnum Financial Group of Shelton, Connecticut. He can be reached at (203) 513-6169.