Ah, the Roth IRA. That single bastion of non-taxable money in our arsenal of accounts. When you have investments in a Roth IRA, you can take the money out tax-free, right? Not always.
There are several situations where a Roth IRA’s monies can be subjected to tax, penalty, or both. Listed below are some of those circumstances.
When a Roth IRA is Taxable
It should be noted that contributions to a Roth IRA may always be withdrawn from the account tax-free, for any purpose whatsoever. There are no restrictions on these withdrawals.
1. Taking the money out of the account within the first five years of the account’s existence can result in taxation of a portion of the funds. The portion that is taxable is any withdrawal that exceeds the total of all contributions and conversions into the account. This rule applies without exceptions.
2. If your Roth IRA has been in existence for the required five-year time, there are still some qualifications to meet in order to ensure that the withdrawals are completely tax free. Specifically, you must
- be at least 59½ years of age; OR
- you must be disabled; OR
- you must be taking no more than $10,000 more than the contribution and conversion amount(s) for a first-time home purchase; OR
- the account owner has died.
If none of those qualifications applies, any amount greater than the conversion/contribution amounts will be subject to ordinary income taxation.
When a Roth IRA is Subject to Penalty
In addition to the specter of taxation, withdrawals from the Roth IRA could also be subject to a 10% early withdrawal penalty (much like a traditional IRA can be). Here are a couple of cases when the 10% penalty may apply:
1. Within five years of any conversion into a Roth IRA, if you take out amounts that include the converted funds, the withdrawal of the converted amounts will be subject to the 10% penalty. (unless one of the exceptions applies – see 19 Ways to Withdraw IRA Funds Without Penalty for more details)
2. Even after the five year period has elapsed, if you are under age 59½ and none of the exceptions from #2 in the “Taxable” section above applies, any amount withdrawn that is greater than the conversions and contributions to the account will also be subject to the 10% penalty.
If the above is a bit confusing, you might need a refresher on the withdrawal sequence – how each dollar of withdrawal from a Roth IRA is attributed, and in what order. Here’s how it goes:
First, all contributions to the account are withdrawn. After that, all conversion amounts are withdrawn, starting with the amounts that have been converted for more than five years, and then subsequently any amounts that were converted less than five years ago (and therefore subject to penalty unless an exception applies).
After all conversions and contributions have been withdrawn, any growth in the account is withdrawn. Growth occurs when the investments in the account gain in value or generate dividends and/or interest. This money is taken out of the account last – and is the most likely to be both taxable and penalized if taken out before the stipulations above have been met.
For more detail on the withdrawal sequence, see the article Ordering Rules for Roth Distributions.
IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).