Roth IRAs are similar to Traditional IRAs, but the main difference between the two is how they are taxed. Traditional IRA contributions are made with pre-tax dollars whereas Roth IRA contributions are made with after-tax dollars. Another major difference between the two retirement accounts is that Roth IRAs are more versatile than Traditional IRAs. A Roth IRA was originally created to be used as a tool for retirement, but what some people may not realize is that a Roth IRA is quite flexible and can serve many purposes. Typically you are not allowed to withdraw your earnings from a Roth IRA until you have held the account for at least five years and are 59 ½. We’re going to explore four different ways that a Roth IRA can be used, three of which are alternatives uses that allow you to take distributions before the age of 59 ½.
First and foremost a Roth IRA can be used for what it is most commonly known for, as a retirement account. As stated above, the contributions made to a Roth IRA are after-tax dollars. Net income after the deduction of all federal, state, and withholding taxes is what after-tax income is. Since the contributions have already been taxed the qualified distributions taken from the Roth IRA will be tax-free. Opening up a Roth IRA and making consistent contributions to it will help you fund your retirement expenses.
Purchase a House
Aside from helping you fund retirement, the next best use for a Roth IRA is to help you buy a home. In order for this to qualify the money withdrawn must be used to pay directly for the home’s down payment or closing costs. The withdrawal from the Roth IRA is capped off at $10,000 for each individual ($20,000 for married couples – $10,000 from each account). Also, you must use the funds you withdraw to help purchase your main home, not a secondary home. One final rule is that you need to be a first time home buyer, which means that neither you nor your spouse have owned a home within the past 2 years. The five year rule still applies here, but any early withdrawals on earnings are exempt from the 10% early withdrawal penalty and are tax-free.
Using a Roth IRA to help fund a child’s education is one of the additional benefits a Roth IRA offers. First, the funds being taken from the Roth IRA must be used towards qualified education expenses. The qualified education expenses include enrollment or attendance at an eligible higher education institution, tuition and fees, room and board, and books, supplies, and equipment. These funds can be used for yourself, your spouse, your children, or your grandchildren. Although you are allowed to use the funds for qualified education expenses, the early withdrawals on earnings from the account will still be taxed but avoid the 10% early withdrawal penalty.
Although it is not recommended it is still an option to use a Roth IRA as an emergency fund. When a Roth IRA is opened all contributions made are allowed to be taken out at any point in time, after the 5 year rule, penalty and tax-free. If any of the earnings are withdrawn from the account prior to age 59 ½ and meeting the 5 year rule for any non-qualified expenses the account will face both penalties and taxes. A Roth IRA should be used as a last resort for funding an emergency account.
Keep in mind that even though a Roth IRA is very flexible and allows you to use it for alternative uses the main objective of it is to fund retirement. Make a conscious effort to use a Roth IRA as its intended purpose. Try to take advantage of its versatility only in times of need.