By Sarah Brenner, JD
Director of Retirement Education
The benefit of funding a Roth IRA is the availability of tax-free distributions in the future. You pay taxes now on your contribution (or conversion) in exchange for tax-free earnings down the road. The rules can be complicated. Don’t miss out on Roth IRA benefits by making mistakes when you take a distribution. Here are five steps for tax-free Roth IRA distributions.
1. Follow the ordering rules. For tax purposes, all of your Roth IRAs are considered one Roth account. There is no tax benefit gained by keeping conversions in a separate Roth IRA from your contributions. This is sometimes called the “aggregation rule.” Funds leave your Roth IRAs in a certain order. Contributed amounts are distributed first. Converted amounts are distributed next, first in, first out. Last out would be earnings.
2. Your contributions are always available tax- and penalty-free. Not only do your contributions come out first, they are always available tax- and penalty-free. This means that if you need to tap your Roth IRA, you can easily access contributions without adverse tax consequences.
3. Watch out for the 10% penalty on converted funds. Converted funds are always distributed tax-free. This makes sense since you already paid taxes when you converted them. However, amounts that were taxable at conversion may be subject to the 10% early distribution penalty if you are under the age of 59½ at the time of the distribution and the conversion was less than five years ago. This five-year clock begins separately for each conversion you do. What if you are over age 59½ when you take converted dollars from your Roth IRA? Then, you have no worries about this five-year clock.
4. Know when earnings are tax-free. Earnings are not subject to tax if the distribution is a qualified distribution. Your distribution is “qualified” if it is made after you have owned any Roth IRA account for five years AND you are over the age of 59½, or are dead, disabled, or taking the funds for a first-time home purchase.
5. Understand the five-year clock for qualified (over age 59½) distributions of earnings. The five-year period for qualified distributions of earnings can be confusing. It is different than the five-year period for penalty-free distributions of converted funds discussed above. It does not re-start with each Roth IRA contribution or conversion. If you contributed $1 to your Roth IRA for 2020, and then in 2022 you converted your one-million-dollar traditional IRA to the Roth IRA, then as of January 1, 2025, all the Roth money would be considered to have been held for five years. Your original Roth IRA 5-year clock began on the first day of the year for which the first dollar of Roth contributions was made.
If you have technical questions you would like to have answered, be sure to submit them to mailbag@irahelp.com, to be answered on an upcoming Slott Report Mailbag, published every Thursday.
https://irahelp.com/5-steps-for-tax-free-roth-ira-distributions/