When Are Roth IRA Distributions Tax-Free?
Roth IRA withdrawals are tax-free in three situations:
1. If you withdraw an amount that does not exceed your original contributions, regardless of your age.
2. If you are 59 and a half years old or older and have had a Roth IRA for five years or more, measured from the first day of the year you established and contributed to it.
3. If you are under 59 and a half years old and have had a Roth IRA for five years or more, but you are withdrawing due to disability, or you are the beneficiary inheriting the Roth IRA, or you qualify for an exception because the withdrawal is being used to purchase or build a first home as explained in IRS Publication 590-B (Early Withdrawals, Exceptions Section).
When Are Roth IRA Distributions Taxable?
Your Roth IRA distributions may be taxable under certain circumstances:
1. If you do not meet the five-year rule for opening a Roth IRA and are under 59 and a half years old, you will owe taxes. You will pay income taxes and a 10% penalty tax on the earnings you withdraw. The 10% penalty tax can be waived, however, if you meet one of the eight exceptions to the early withdrawal penalty.
2. If you do not meet the five-year rule but are over 59 and a half years old, you will owe taxes. The distributed earnings will be included as income and subject to income taxes, but not the 10% penalty tax.
3. If you have met the five-year rule but have not yet reached 59 and a half years old, you will owe taxes. The earnings that are withdrawn – not the contributions – will be considered income and subject to income taxes and a 10% penalty tax. The 10% penalty tax can be waived if you meet one of the exceptions listed in IRS Publication 590-B.
Examples of How Roth IRA Distributions Are Taxable
Let’s say Sally is 58 years old, has opened her first Roth IRA with a contribution of $6,000. She also rolled over $50,000 from a traditional IRA into this Roth IRA. Sally turns 60 with her Roth IRA worth $60,000 after two years. She withdraws it all to buy a mobile home.
Sally does not pay any taxes on her $6,000 contributions and does not pay income tax or the 10% penalty tax on the $50,000 from the rollovers because she paid taxes already at the time the rollover was made. There is no penalty for Sally because she is over 59 and a half. Sally only pays income tax on the $4,000, which is from the earnings because she has not yet satisfied the five-year rule.
Assume John is 58 years old, has had his Roth IRA for over five years, with a balance of $20,000. His original contributions amounted to $10,000, and last year he rolled over $8,000 from his traditional IRA to his Roth IRA. The additional $2,000 from the Roth IRA is from investment earnings. John withdraws all from Roth IRA.
John does not pay any taxes on the first part of the withdrawal of $10,000 because he is taking out his original contributions. He pays a 10% penalty tax on the next part of the withdrawal of $8,000 because it has not been more than five years since the rollover. John pays income tax and a 10% penalty tax on the last part of the withdrawal of $2,000 which is from investment earnings because he does not meet both qualifications of the five-year rule and being over 59 and a half years old, and does not meet any exceptions. John would not pay any taxes on this part of the withdrawal if he were over 59 and a half.
Transfers
Roth IRA vs. Gains
Your distributions from a Roth IRA are considered to occur in a specific order when you take them from your Roth IRA, depending on whether they are contributions, conversions, or gains:
1. Regular contributions are distributed first. These contributions come out tax-free, regardless of age or how long it has been since you opened the Roth IRA.
2. Conversion amounts are distributed on a priority basis. The taxable portion that you had to include in your gross income at the time of the conversion is distributed first. The non-taxable portions of the conversion amounts follow.
3. Conversion amounts that are distributed later may be subject to a 10% penalty tax.
The five-year countdown begins when funds are converted to Roth, and any amounts you must include in income at the time of the conversion that are withdrawn before the five-year period ends are subject to a 10% penalty tax. This penalty does not apply to distributions from conversions to Roth that occur after age 59 and a half.
Conclusion
Like any retirement account, it’s important to do your best to keep your investments growing as long as possible. The longer your money can stay invested and grow, the better off you’ll be. Talk to a financial planner first to understand how it will impact your future if you plan to use your retirement funds to make a large purchase.
Frequently Asked Questions (FAQs)
Are Roth IRA distributions considered income?
As long as you qualify, your Roth IRA distributions will not be considered income. To qualify, you must be over 59 and a half and the account must have been open for at least five years, although there are some exceptions.
How are taxes applied to distributions from a Roth IRA?
When you withdraw from a Roth IRA before the account has been open for five years and/or you are under age 59 and a half, you may have to pay a 10% penalty and regular income taxes on the amount.
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Sources:
IRS. “Publication 590-B Distributions From Individual Retirement Arrangements (IRAs).”
Fidelity. “Why Consider a Roth Conversion Now?”
IRS. “Roth Comparison Chart.”
Source: https://www.thebalancemoney.com/are-roth-ira-distributions-taxable-2388706-2388706
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