The Scoop on Roth Iras - Are Withdrawals Tax-Free or Not?

When Are Roth IRA Withdrawals Tax-Free?

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Below are a simple set of rules you can use to determine if your Roth IRA withdrawal will be tax-free or not.

Are Roth IRA Withdrawals Tax-Free?

Your Roth IRA withdrawal will be tax-free if:

  1. You withdraw just the amount of your original contributions, regardless of your age.
  2. You are age 59 ½ or older and have had your Roth for five years or longer (as measured from the first of the year for which you first established and contributed to your Roth).
  1. You are under age 59 ½ and have had your Roth IRA for five years or longer, but are taking the distribution because you are disabled, you are 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 Withdrawals Taxable?

Your Roth IRA withdrawals may be taxable if:

  • You’ve not met the five-year rule yet for opening the Roth and you are under age 59 ½: You will pay income taxes and a 10% penalty tax on earnings that are withdrawn (the 10% penalty may be waived if you meet one of the eight exceptions to the early withdrawal penalty tax).
  • You’ve not met the five-year rule but you are over age 59 ½: Earnings withdrawn will be included as income (and subject to income taxes) but will not be subject to a 10% penalty tax.
  • You’ve met the five-year rule but are not yet 59 ½: Earnings withdrawn will be considered as income (and thus subject to income taxes) and subject to a 10% penalty tax (the 10% penalty may be waived if you meet one of the exceptions listed on page 64 of IRS Publication 590).

    The above section talks about earnings. Earnings are not the same as contributions or conversion amounts. There are a set of ordering rules for distributions covered in IRS Publication 590 which dictate that when you take withdrawals from Roth IRAs, your withdrawals are deemed to occur in a specific order as far as which part of the withdrawal is contributions, conversions or earnings.

    Here's how it works:

    1. Regular contributions are withdrawn first. As discussed in section I above, these come back out tax-free regardless of age or length of time since you opened the Roth.
    2. Conversion and rollover amounts on a first in, first out basis. ( The taxable portion which you had to include in gross income because of the conversion first, non-taxable portion of conversion/rollover amounts next.) Conversion or rollover amounts that are subsequently withdrawn may be subject to a 10% penalty tax. This provision is intended to keep people under age 59 1/2 from taking a regular IRA, converting it to a Roth, and then the next year taking a distribution, thereby circumventing the traditional IRA early withdrawal penalty tax. To prevent this, when you convert funds to a Roth, a five-year clock starts ticking and any amounts that you had to include in income at the time of the conversion that is subsequently withdrawn before the five-year clock is up, are subject to a 10% penalty tax. This 10% penalty does not apply to distributions from Roth conversions that occur at age 59 ½ or thereafter.
    3. Earnings on contributions. Earnings on contributions that are withdrawn are subject to income taxes and the 10% penalty tax unless you meet qualifications under item 2 or 3 in Section I above.

      Below are a few examples to show you how to apply these rules.

      Example 1: Sally

      • Sally is 58.
      • She opens her first ever Roth and contributes $6,000. She converts $50,000 from a Traditional IRA to this Roth IRA.
      • Two years later, Sally reaches age 60.
      • Her Roth is worth $60,000.
      • She cashes it all in to buy a motor home.
      • Sally pays no tax on her $6,000 of contributions.
      • She pays no income tax or penalty tax on her $50,000 from conversions (she already paid tax at the time she converted and has no penalty as she is over age 59 ½).
      • She pays income tax on the $4,000 attributable to earnings (because she has not met the five-year rule), but no penalty tax.

      If Sally had only withdrawn $56,000 none of it would be taxable, and the earnings could be left for another 3 years at which point they could be withdrawn tax-free.

      Example 2: John

      • John is 58 and has had his Roth IRA over five years.
      • He has $20,000 in his Roth IRA.
      • $10,000 of it came from his original contributions.
      • Last year he converted $8,000 from a traditional IRA to his Roth.
      • $2,000 of his Roth is from investment gains.

      John cashes in his entire Roth IRA.

      • On the first $10,000 of withdrawal, he pays no tax, since he is withdrawing his original contributions.
      • On the next $8,000 of withdrawal, he pays a 10% penalty tax since it has been less than five years since the conversion.
      • On the last $2,000 of withdrawal, which is all investment gain, he pays income tax and a 10% penalty tax because he does not meet the dual requirements of the five-year rule and being over age 59 ½, and does not qualify for any of the exceptions to the penalty. If he was over age 59 1/2, he would pay no tax on this portion of the withdrawal. If he was over age 59 ½ but had not met the five-year rule, he would pay income tax but not a penalty tax on this portion of the withdrawal.

      The above withdrawal guidelines should help you figure out if you will owe tax on a Roth distribution. Keep in mind, Roth 401(k)s, called Designated Roth Accounts, work a little differently, so if you have money in a Roth 401(k) at work, not all of the rules above apply.