Learning the rules can help you determine whether your Roth IRA distributions will be tax-free or not.
When Are Roth IRA Distributions Tax-Free?
Your withdrawal from a Roth IRA isn’t taxable under three circumstances:
You withdraw no more than the amount of your original contributions, regardless of your age. You’re 59 1/2 or older and you’ve had your Roth for five years or longer, measured from the first day of the year in which you established and contributed to it. You’re under age 59 1/2 and you’ve had your Roth IRA for five years or longer, but you’re taking the distribution because you’re disabled, you’re the beneficiary inheriting the Roth, or you meet an exception because the distribution is being used to buy or rebuild a first home as described in IRS Publication 590-B (Early Distributions, Exceptions section).
When Are Roth IRA Distributions Taxable?
Your Roth IRA distributions might be taxable under certain circumstances. If you haven’t met the five-year rule for opening the Roth and you’re under age 59 1/2, you’ll have to pay taxes. You’ll pay income taxes and a 10% penalty tax on earnings you withdraw. The 10% penalty can be waived, however, if you meet one of eight exceptions to the early-withdrawal penalty tax. If you haven’t met the five-year rule, but you’re over age 59 1/2, you’ll owe taxes. Distributed earnings will be included as income and subject to income taxes, but they won’t be subject to the 10% penalty tax. And if you’ve met the five-year rule, but you’re not yet age 59 1/2, you’ll have to pay taxes. Earnings that are withdrawn—but not contributions—will be considered income and will be subject to income taxes and a 10% penalty tax. The 10% penalty can be waived if you meet one of the exceptions listed in IRS Publication 590-B.
Examples of How Roth IRA Distributions Are Taxed
Suppose Sally is 58, and they open their first Roth with a contribution of $6,000. They also convert $50,000 from a traditional IRA to this Roth IRA. Sally reaches age 60 with a Roth IRA worth $60,000 two years later. They cash it all in to buy a motorhome. Sally pays no tax on the $6,000 in contributions and pays no income tax or the 10% penalty tax on the $50,000 from conversions because they already paid tax at the time it was converted. Sally has no penalty because they are over age 59 1/2. Sally only pays income tax on the $4,000 that is attributable to earnings because the five-year rule has not been met. John is 58, and they have had a Roth IRA for more than five years, with a balance of $20,000. Their original contributions totaled $10,000, and last year, they converted $8,000 from a traditional IRA to their Roth. Another $2,000 of the Roth is from investment gains. John cashes in the entire Roth IRA. John pays no tax on the first $10,000 of the distribution because they’re withdrawing the original contribution. They pay a 10% penalty tax on the next $8,000 of the distribution because it’s been less than five years since the conversion. John pays income tax and a 10% penalty tax on the last $2,000 of distribution, which is all investment gains, because they don’t meet the dual requirements of the five-year rule and, being over age 59 1/2, and they don’t qualify for any exemptions. John would pay no tax on this portion of the distribution if they were over age 59 1/2. John would pay income tax, but not a penalty, on this portion of the distribution if they were over age 59 1/2 but hadn’t met the five-year requirement.
Roth IRA Conversions vs. Earnings
Your distributions are deemed to occur in a specific order when you take them from a Roth IRA, depending on whether they’re contributions, conversions, or earnings. Regular contributions are distributed first. These come out tax-free, regardless of age or the length of time that’s passed since you opened the Roth. Conversion and rollover amounts are distributed on a first-in, first-out basis. The taxable portion that you would have been required to include in gross income at the time of the conversion is distributed first. The non-taxable portions of conversion/rollover amounts are next. Conversion or rollover amounts that are subsequently distributed can be subject to the 10% penalty. A five-year clock begins running when you convert funds to a Roth, and any amounts that you had to include in income at the time of the conversion and that are withdrawn before the five-year period is up are subject to the 10% penalty. This penalty does not apply to distributions from Roth conversions that occur after age 59 1/2.
The Bottom Line
Like any retirement account, it’s important to do your best to keep the money invested as long as you can. The longer your money can stay invested and grow, the better off you will be. Talk to a financial planner first to see how it will impact your future if you plan to use your retirement funds for a major purchase.
