Ordering of Roth Distributions
As many investors know, a Roth IRA can be a powerful piece in your financial plan. Most are familiar with the key advantages a Roth provides. Specifically, tax free growth and no required minimum distributions (RMDs).
Another perk is that contributions (not earnings) can be withdrawn anytime tax- and penalty-free. For these reasons and more, many investors make annual Roth Contributions and/or perform Roth Conversions.
What’s less commonly understood is, how are distributions treated by the IRS if you take money out from the account earlier than initially planned?
If you withdraw funds before age 59 ½, which dollars come out first, and how are they taxed?
- Contributions
Regular Roth IRA contributions are always the first dollars withdrawn. Since these are made with after-tax money, they can be taken out anytime, tax- and penalty-free, regardless of age.
- Converted Funds
Converted funds are second in the ordering of Roth distributions. Provided the account meets the 5-year holding period for conversions, there is no income tax and no early withdrawal penalty. If the account fails to meet the 5-year holding period there is no income tax, but a 10% early withdrawal penalty. If there is a special purpose, such as being of age 59 ½, or death/disability, there are no tax or penalty implications regardless of holding period on converted funds.
- Earnings
Earnings are the final portion to come out of the account. If the distribution is non-qualified, meaning there are no triggering events (attaining age 59 ½, …) or special purposes (Birth/adoption…) the earnings portion is subject to both income tax and a 10% early withdrawal penalty.
Of course, if the account holder has reached age 59 1/2, and has met the 5-year holding period requirement, all earnings come out tax and penalty free.
Understanding which slices of the Roth IRA are accessible can an important distinction for many investors.
As always, I recommend working with a financial advisor to review your specific situation, and to ensure optimal asset location withing your financial plan.
-Bill Rautiola, RICP ®, AIF ®, PPC ®
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
