MW A flood wiped out my employer, can I tap into my Roth or regular IRA without penalty?

By Dan Moisand

There should be some funds available to you on a more tax-friendly basis

Dear Dan,

I lost my job when a flood wiped out the store where I worked. I am 37, have a Roth IRA and a regular IRA. The Roth was started 12 years ago. What are the best ways to get cash from these and minimize taxes? Would a conversion help me avoid the 10% penalty?

- Flooded Out

Dear Flooded Out

I'm so sorry to hear this. That has to be rough.

I'm going to assume all the funds in the traditional IRA are pretax. Unless an exception applies, taking any of those funds or earnings from your Roth IRA will result in taxable income and a 10% penalty for being under age 591/2. Nonetheless, there should be some funds available to you on a more tax-friendly basis. Qualifying for some of the exceptions I'll mention can be tricky so you should consult your tax adviser before taking any distributions.

The most important exception I see pertains to IRA withdrawals. If your area has been named a Major Disaster area by FEMA and you suffered an economic loss from that event, within six months of the loss, you may remove up to $22,000 from your IRA penalty free. You will pay only the normal taxes. The income from such distributions is spread over three years unless you elect to include it in year of distribution. It used to be Congress had to pass legislation to allow for such relief but now it is automatic based on the Federal declaration of a major disaster area.

Read: You can now use your 401(k) to rebuild after a natural disaster - but should you?

In addition, if you get unemployment compensation, you may qualify to pull enough from the IRA to pay medical insurance premiums. Those distributions would be taxable but penalty free. If you have unreimbursed medical expenses that are more than 7.5% of your Adjusted Gross Income, you may be able to pay for those with taxable but penalty free IRA distributions.

You could also start a series of "Substantially Equal Periodic Payments" $(SEPP)$ to tap the IRA without penalty. One of several tricky parts with a SEPP plan is there are significant limitations including the requirement to continue the program until you turn 59 1/2.

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Moving on to the Roth IRA, distributions from your Roth IRA are made based on the following ordering rules:

-- The first dollars out are deemed to be from your regular contributions. Since contributions are made after-tax, these withdrawals are tax-free. There is no time or age consideration here.

-- Once you have distributed the equivalent of the total amount of your contributions, the next dollars out are deemed to be amounts converted more than five years ago. You would have paid the tax for the year of the conversion. Since these converted amounts are more than five years old, the five-year rule applicable to conversions is satisfied and no tax or penalty is due.

-- Next out are amounts converted less than five years ago. You would have paid the tax for the year of conversion but not paid the 10% penalty that normally applies to amounts coming out of an IRA prior to age 59 1/2. So, if you take out more than the contributions in No. 1 and the older conversions in No. 2 and are still under 59 1/2, you pay the 10% when you distribute these converted funds. At 37, this means converting now will not help you avoid the 10% penalty.

-- Anything left in the account after all contributed and converted amounts have been distributed is by default the earnings. A second five-year rule is a factor here. For the earnings to be tax-free, it must have been at least five years since you opened your first Roth IRA, even if that account is not still open, and you must be at least 591/2 years old. Therefore, at 37, if you take more than the amount in 1 - 3 those amounts are taxable, and you will also owe a 10 % penalty, unless an exception applies.

Say you made $5,000 in contributions to the Roth IRA 10 years ago, never contributed more or converted anything and the account is now worth $20,000. The first $5,000 you take is tax free (No. 1 above). Because No. 2 and No. 3 do not apply, the remaining $15,000 will be earnings. If you remove any of those earnings, you'll pay the appropriate tax plus a 10% penalty.

If you have a question for Dan, please email him with 'MarketWatch Q&A' on the subject line. Dan's comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some reader questions are edited to aid the presentation of the subject matter.

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-Dan Moisand

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March 23, 2025 21:42 ET (01:42 GMT)

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