Transcript
Today’s question comes from Ken in Satellite Beach. He says, I thought once you turned 59 and a half, Roth IRAs are tax-free. But a 63-year-old coworker insists that he had to pay some tax last year when he withdrew from his Roth IRA. What gives.
Well, Ken, it is possible to owe taxes on a Roth IRA distribution. However, most people could easily avoid doing so by navigating one of or actually two, five-year rules. And one of those could be the culprit, that one states that earnings are taxable if withdrawn within five years of the opening of a taxpayer’s very first Roth IRA, regardless of the taxpayer’s age. Now, I suspect your coworker opened his Roth fairly recently. If not, he just might be reporting it incorrectly. Now, ideally, Roth IRAs are left alone to grow over time and not used until needed after retirement. But if cash is needed, some funds can be accessed tax-free at any age. How much? Well, that’s dependent on how the account was funded and the rules regarding distributions.
Now we have a concise description of other rules applicable to Roth IRA taxation and an example of how they apply in the post on our website titled When A Roth IRA Distribution is Taxable. Now, also in that post is a rundown of other Q&As that we produced stories which we served as a source and some news items of note, including our inclusion in the list of America’s top 100 firms and our fourth appearance in five years on a national list of best places to work for financial advisors. As always, if you have questions, please contact us. We’d love to hear from you.
When are Roth IRA distributions taxable?
From Ken in Satellite Beach: I thought once you turned 59 ½, Roth IRAs are tax-free, but a 63-year-old co-worker insists he had to pay some tax last year when he withdrew from his Roth IRA. What gives?
Ken, it is possible to owe taxes on a Roth IRA distribution. However, most people can easily avoid doing so by navigating two five-year rules.
The first states that if you distribute amounts that were converted to the Roth IRA less than five years after the conversion and you are under age 59 ½, a penalty of 10% of the distribution will apply. This rule applies to each conversion separately. Your co-worker is over 59 ½, so this rule is not the issue.
The second five-year rule could be the culprit. It states that earnings withdrawn within 5 years of the opening of a taxpayer’s very first Roth IRA are taxable, regardless of the taxpayer’s age. If under 59 ½, a 10% penalty is also assessed. Once it has been five years since the opening of the first Roth IRA and the owner reaches age 59 1/2, this rule is no longer an issue, even if the original Roth IRA no longer exists, and all distributions would be tax-free.
Ideally Roth IRAs are left alone to grow over time and not used until needed after retirement…
Ideally, Roth IRAs are left alone to grow over time and not used until needed after retirement, but if cash is needed, some funds can be accessed tax-free at any time. How much is dependent on how the account was funded and the rules regarding distributions.
When you distribute any funds from a Roth IRA, a set of ordering rules applies.
- The first dollars out are deemed to be from your regular contributions. Since contributions are made after-tax, these withdrawals are tax-free.
- Once you have distributed the equivalent of the total amount of your contributions, the next dollars out are deemed to be amounts converted more than 5 years ago. You would have paid the tax at the time of conversion, so no taxes are due upon withdrawal from the account. Since these converted amounts are more than 5 years old, the five-year rule applicable to conversions is satisfied, and no penalty is due on these distributions either.
- Next out are amounts converted less than 5 years ago. You would have paid tax at the time of conversion, but not paid the 10% penalty that normally applies to amounts coming out of an IRA before age 59 ½. So, if you take out more than the contributions in #1 and the older conversions in #2 and are still under 59 1/2, you pay the 10% penalty when you get to these converted funds.
- The last thing out after taking all prior contributions and conversions is, by default, deemed to be the earnings. The second five-year rule is a factor here. For the earnings to be tax-free, you must be at least 59 ½, and it must have been at least five years since you opened your first Roth IRA.
So, say you made $20,000 in contributions over the years, converted $30,000 six years ago, and another $30,000 two years ago, and the account is worth $90,000. The first $20,000 you take is tax-free (#1 above), as is the next $30,000 (#2). The next $30,000 (#3) removed is tax and penalty-free if you are over 59 ½. If you are under 59 ½, you’ll owe a $3,000 penalty (10% of $30,000). The last $10,000 is earnings and is taxed based on item #4 above.
The accounting for this is done on IRS Form 8606 whenever you make a contribution, conversion, or distribution until both five-year rules are satisfied.