Many (including us) have touted the benefits of saving for retirement via the Roth IRA. As you may well be aware, even though there is no upfront income tax deduction for qualified Roth IRA contributions, the earnings within your account can grow tax-free over time and you pay no income tax on distributions from your account in retirement. But its important to understand the rules regarding Roth distributions – not every type of withdrawal is tax-free. Furthermore, some Roth IRA withdrawals may be hammered with a 10% penalty in addition to being subject to regular income tax rates.
Here are the basic rules – If you are 59 1/2 or older and have had at least one Roth IRA open for over five years, your withdrawals are considered “qualified” and therefore free of any income tax or penalty. The 5-year period begins on January 1st of the tax year in which you made your first Roth contribution.
Its also important to understand that there may be up to 3 “layers” or types of funds held within a Roth IRA. The first layer consists of your contributions to the account. These funds may be withdrawn at any time tax and penalty free. Nonqualified withdrawals are always deemed to come first from this layer so it is important to track your accumulated contributions over the years you own the Roth. For example, if you have contributed $3,000 dollars per year to a Roth IRA for 3 years and the account value has grown to $10,500 you may withdraw the $9,000 “contribution layer” even if you do not meet the 59 1/2 or 5 year rule.
Next, nonqualified withdrawals are deemed to have come from Roth conversion contributions, if any. These are contributions that were originally made to a traditional IRA and later converted to Roth. When you make this conversion you generally pay income tax on the contributions you previously received a tax deduction for. The tax is paid at the time of conversion so if you make a withdrawal at a later date you won’t get hit again with income tax. You may, however still pay the 10% penalty if you make the withdrawal within five years of the conversion and don’t meet one of the penalty exceptions discussed in IRS Tax Topic 558 .
Once you have withdrawn all your Roth contributions (regular and conversion) a nonqualified withdrawal is deemed to come from your Roth IRA earnings. This layer of withdrawals is 100% taxable and subject to the 10% penalty unless your have met the 59 1/2 and 5 year rules.
Keep in mind that any time you take a distribution from your Roth IRA, you will receive a 1099-R from the institution or investment firm that holds your account. The total amount of the withdrawal is reported on line 15a of your Form 1040 (U.S. Individual Income Tax Return) and the taxable portion (if any) is reported on line 15b. Form 8606 is used to report your accumulated contributions to the Roth (i.e. basis) and compute any taxable withdrawals. The IRS receives a copy of the 1099-R so you want to make sure all required forms are completed correctly and you have adequate records of contributions made in prior years.
Stephen Osborne, CPA