Tax and Penalty-Free
Qualified distributions from a Roth IRA are not taxed. Contrast this with a Traditional IRA where the owner goes into it knowing that he will eventually face the tax man. The idea behind the Roth is to contribute after-tax money and then get tax-free distributions later. This feature is very important to those who may be in a higher tax bracket during retirement.
Having said that, a person may withdraw Roth contributions for any reason and at any time and not suffer taxes or penalties. This is because the IRS does not tax contributions twice. Once prior contributions are withdrawn, however, the IRS taxes premature distributions of earnings. This concept is best explained by example:
Example: Sam Smith opened a Roth IRA in 1998 with a $2,000 contribution when he was 40 years old. He made subsequent contributions of the same amount in 1999 and 2000, for a total of $6,000 in contributions. His Roth IRA did very well and grew to a total value of $12,000 as of December 31, 2001. His Roth IRA therefore consists of $6,000 from contributions and $6,000 from earnings.
Sam Smith may withdraw up to the amount of his contributions ($6,000) tax and penalty free. He's already paid taxes on that amount, so the IRS does not tax it again. Taxes and penalties, however, enter the picture if Sam starts to withdraw his earnings depending upon Sam's situation.
Ordering of Withdrawals
How do we know whether the Roth withdrawal was from contributions, conversions, or earnings?
Withdrawals are assumed to occur in the following order:
Using the example from the previous page, if Sam Smith withdrew $8,000 from his Roth IRA, $6,000 is assigned to contributions and $2,000 to earnings. Sam did not convert money to his Roth from another IRA, so conversion is ignored. Only $2,000 of the withdrawal is subject to taxes. That same $2,000 is also subject to a 10% penalty if the reason is not qualified.
Conversion Distributions - Tax Free?
Conversion means that money was converted to a Roth IRA from a Traditional IRA. The act of converting funds from Traditional to Roth results in tax consequences for the owner, as the converted amounts are added to income and taxed at ordinary rates on the owner's tax return. Conversions were first allowed in 1998 subject to certain income restrictions. Most people who did the conversion in 1998 elected to spread the tax consequences over a 4-year period, which Congress allowed to reduce the tax shock for early adopters.
For example, let's say that Jake Brown had $100,000 in his Traditional IRA that he converted to a Roth IRA in 1998, and elected to spread the tax consequences over a 4-year period. Therefore, Jake reported an extra $25,000 income on his tax returns in 1998, 1999, 2000, and 2002 and paid taxes on his total income at ordinary rates each year. Meanwhile, the entire $100,000 was converted in 1998 and began growing as a Roth IRA at that time.
OK, Jake has paid taxes on his converted amounts. Can he withdraw the $100,000 without suffering further tax consequences? If so, when?
The answer is "yes" with one condition: Jake must satisfy a 5-year holding period before he may take a distribution on the converted money without suffering a penalty. The 5-year count began in 1998 on the entire $100,000 although he only reported $25,000 on his tax return that year. The 5-year holding period is fully satisfied the first day of 2003, which means that Jake may withdraw the entire $100,000 tax and penalty free on or after January 1, 2003. A distribution taken before 2003 is subject to a 10% penalty.
If Jake had a separate IRA that he converted to a Roth in 2000, he must wait until 2005 to withdraw funds from that conversion to avoid tax consequences. The idea is that each conversion is treated separately. Furthermore, note that converted amounts may be withdrawn tax and penalty free. Withdrawal of earnings is treated differently.
Earnings Distributions - The First Condition
Withdrawal of Earnings Tax & Penalty Free: An individual must meet two separate tests to avoid taxes and penalties when taking a distribution of earnings from a Roth IRA. With penalties at 10% and ordinary tax rates up to 36% it is certainly worth the effort to understand this concept.
Tax Forms: Taxpayers file forms 8606 (basis) and 5329 (purpose) to identify the portion of the IRA withdrawal subject to taxes.
"5-Year Rule" is the first test. That is, the distribution of earnings must take place five years after the first contribution. Year one starts with the year of contribution. A Roth IRA with its first contribution in tax year 1998 completes the five-year holding period on January 1, 2003. Partial or total withdrawals of earnings on or after that date have cleared this important hurdle.
Roth IRAs became legally operational in 1998. This means qualified distributions first took place in 2003. However, meeting the 5-year holding period by itself is not sufficient to avoid taxes or penalties when distributing earnings. At least one other condition must be present!
Using the Sam Smith example from the first page to show the 5-year rule in operation, let's say Sam withdrew all $12,000 from his IRA in 2002 (he does not meet the 5-year rule).
5-Year Holding Period Table
Earnings Distributions - The Second Condition
Age 59½ at the Time of Withdrawal: If the IRA owner is 59½ at the time of his first withdrawal and his first Roth contribution occurred 5 years prior, he may withdraw 100% of his Roth IRA tax and penalty free. Passing the age test satisfies the second condition. Others are below.
However, a recent conversion - as discussed previously - may complicate the matter. Remember that distributions follow IRS ordering rules: 1) contributions, 2) conversions, and 3) earnings. A Roth IRA may have conversion money mixed in that must pass its own 5-year test to avoid taxes and penalties.
Account Owner is Disabled: Coupled with meeting the 5-year rule, this is also reason for tax and penalty free distributions. If the 5-year rule is not fulfilled, the account owner may ncur taxes on earnings but not a penalty.
Death Distributions to a Beneficiary or Estate: Coupled with the 5-year rule this is also a reason for tax and penalty-free withdrawals. Beneficiaries are liable for taxes if the account does not meet the 5-year rule upon distribution. Beneficiaries may elect to hold funds in the original owner's IRA until the 5-year rule is fulfilled and then take a distribution, or take smaller payments of contribution amounts only until the 5-year rule is fulfilled, and then take the earnings.
Qualify as a First-Time Home Buyer: Up to $10,000 qualifies for this exemption. Coupled with the 5-year rule this is also reason for a penalty free withdrawal. If the 5-year rule is not met the account owner will incur taxes but not a penalty.
Examples of Avoiding Tax and Penalty
Owner Turns 59 ½, but Conversion Less than 5-Years Old: Jeff made five ordinary contributions of $3,000 per year to his Roth IRA starting 2001 and ending 2005 (the 5-year test for contributions is fulfilled Jan 1, 2006). He also converted $11,000 from another IRA in 2003 (5-year test fulfilled Jan 1, 2008). He also turns 59 ½ 2006. What are his options for tax-and-penalty free withdrawals in 2006?
Owner's Age under 59 ½, but 5-Year Rule Met: William turns 39 in 2007 when he wants to take a distribution. His first Roth IRA contribution occurred in 1998 (5-year rule fulfilled). What reasons could he use to avoid taxes and penalty on distributions?
Examples of Avoiding Tax and Penalty continued . . .
What about a person who is 72 when he wishes to take his first withdrawal in 2007, but his first IRA contribution occurred in tax year 2005? This person is in the third year of his five-year holding period. He may incur taxes and penalties if he takes a distribution of earnings.
To drive home this point, let's talk about a person who is even older. Recall that Traditional IRA contributions must stop the year the owner reaches 70 ½. However, there is no such upper age limit on Roth IRA contributions.
A Few More Reasons to Avoid a Penalty
You've just learned about a few reasons to avoid both taxes and penalty on distributions after the 5-year holding period has been met.
Now it's time to take the leftovers. That is, there are no more reasons to avoid ordinary taxes. There are, however, a few more reasons to avoid the 10% penalty on a distribution of earnings, as follows.
Again, a customer should consult with a tax professional whenever he wants to withdraw earnings a Roth IRA for any reason if he has not cleared the 5 tax-year hurdle and has no qualifying exception.
The Penalty - By Example
Bill owner wants to take a distribution of $12,000 from his ROTH in 2003 when he is 45 years of age and has cleared the 5-year hurdle. His IRA consists of $6K prior contribution and $6K earnings. However, no other exception applies because he is under 59½, his is not disabled, he did not die (meaning this is not a death distribution), and he is not a first-time home buyer.
No matter what this owner does he will need to report $6,000 of the $12,000 withdrawal as ordinary income on his tax return (and pay taxes on it). However, he may be able to avoid the additional 10% tax on the $6,000 portion because he is working on an advanced degree at the local university. Remember the IRS will waive the extra 10% penalty for the following:
Consequences from this example are as follows: