The Scoop on Roth IRA Withdrawals
When Are Roth IRA Withdrawals Tax-Free?
Investing your savings into a Roth IRA allows you access to more of your money sooner in life without paying taxes and penalties. In some cases, though, your withdrawals may trigger a tax or penalty. 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?
The answer is yes, under the following guidelines:
- If you withdraw just the amount of your original contributions, regardless of your age.
- If you are age 59 1/2 or older and have had your Roth for 5 years or longer (as measured from the first of the year for which you first established and contributed to your Roth).
- You are under age 59 1/2 and have had your Roth IRA for 5 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 5-year rule for opening the Roth and you are under age 59 1/2: You will pay income taxes and a 10% penalty tax on earnings that you withdraw. 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- You’ve not met the 5-year rule but you are over age 59 1/2: Earnings withdrawn will be included as income and subject to income taxes but will not be subject to a 10% penalty tax.
- You’ve met the 5-year rule but are not yet 59 1/2: Earnings withdrawn will be considered as income and subject to income taxes and a 10% penalty tax.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. 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:
Regular contributions are withdrawn first. These come out tax-free regardless of age or length of time since you opened the Roth.
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 5-year clock starts and any amounts that you had to include in income at the time of the conversion that is withdrawn before the 5-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 1/2 or after.
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 the section above.
Applying The Roth IRA Rules
Below are a couple examples to show you how to apply these rules.
Example #1: Sally
Sally is 58, and she opens her first-ever Roth with a contribution of $6,000. She also converts $50,000 from a Traditional IRA to this Roth IRA. Two years later, Sally reaches age 60 with a Roth IRA worth $60,000. She cashes it all in to buy a motorhome.
Sally pays no tax on her $6,000 of contributions and pays no income tax or 10% penalty tax on her $50,000 from conversions because she already paid tax at the time she converted and has no penalty since she is over age 59 1/2. She only pays income tax on the $4,000 attributable to earnings because she has not met the 5-year rule.
If Sally had only withdrawn $56,000, none of it would be taxable, and the earnings could be left for another three years when she could have withdrawn it tax-free.
Example #2: John
John is 58 and has had a Roth IRA more than 5 years with a balance of $20,000. His original contributions totaled $10,000, and last year he converted $8,000 from a traditional IRA to his Roth. Another $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 5 years since the conversion.
On the last $2,000 of withdrawal, which is all investment gains, he pays income tax and a 10% penalty tax because he does not meet the dual requirements of the 5-year rule and being over age 59 1/2, and does not qualify for exemptions. If he was over age 59 1/2, he would pay no tax on this portion of the withdrawal.
If John was over age 59 1/2 but had not met the 5-year rule, he would pay income tax but not a penalty tax on this portion of the withdrawal.
Roth 401(k)s are Different
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.
Like any retirement account, it's important to do your best to keep the money invested as long as you can. Most people have not saved enough for retirement, and the longer the money can stay invested and grow, the better off you are.
If you plan to use your retirement funds for a major purchase, talk to a financial planner first to see how it will impact your future.