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You may never have thought about this, but when you start to take money out of your Roth IRA account(s), there is a specific order to which the distributions are attributed. You might not think it makes a difference, but it does – specifically as it applies to any distributions that are not qualified, and whether or not there is a penalty involved.
Of course, by qualified, the IRS means any distributions that are made after the account has been established for 5 years and one of the following applies:
- you are at least age 59½ years of age;
- the distribution falls under the exception for a first time home purchase;
- the distribution occurs due to the account owner’s complete disability; or
- the distribution occurs after the death of the account owner.
There are other exceptions, which you can read about in the article – 19 Ways to Withdraw IRA Funds Without Penalty.
Otherwise, your distribution could be subject to the 10% early withdrawal penalty – but this is where the ordering rules come in. As you know, commonly your Roth IRA distributions will be tax-free – but this is only when they are qualified distributions (as described above). When you take money out of your Roth IRA account in a non-qualified fashion (e.g., prior to age 59½), a portion of the distribution may be subject to penalty.
Ordering Rules
You may recall that, since there is no special tax treatment (i.e., no deduction) for your regular Roth IRA contributions, you can withdraw these contributions at any time for any reason, without tax or penalty. This is the first part of the IRS’ special ordering rules. Withdrawals from your Roth IRA account are attributed as follows:
- Excess contributions (when you’ve contributed more than you’re legally allowed for a year)
- Regular contributions
- Conversion and rollover contributions, on a first-in first-out basis (total conversions and rollovers from the earliest conversion/rollover year first). See Aggregation (grouping and adding) rules, below. Take these conversion and rollover contributions into account as follows:
- Taxable portion (the amount that was required to be included in gross income because of the conversion) first, and then
- Nontaxable portion (any amount that was not taxed upon conversion or rollover).
- Earnings on contributions.
Disregard rollover contributions from other Roth IRAs for this purpose. These are considered in the same fashion as they would have been in the originating account – so if it was a conversion originally, it’s still considered a conversion for purposes of the ordering rules.
Aggregation (grouping and adding) rules. Determine the taxable amounts distributed (withdrawn), distributions, and contributions by grouping and adding them together as follows.
- Add all distributions from all your Roth IRAs during the tax year together.
- Add all regular contributions made for the year (including contributions made after the close of the year, but before the due date of your return) together. Add this total to the total undistributed regular contributions made in prior years.
- Add all conversion and rollover contributions made during the year together. For purposes of the ordering rules, for example, in the case of any conversion or rollover in which the conversion or rollover distribution is made in 2021 and the conversion or rollover contribution is made in 2022, treat the conversion or rollover distribution as distributed before any other conversion or rollover contributions made in 2022.
Disregard any amount withdrawn to correct an excess contribution (including the earnings withdrawn) for this purpose.
Penalty
So, with the above ordering rules in mind, as you take money out of your Roth IRA, only the part that represents the growth in the account, plus any amount that was converted less than five years prior, will be subject to the 10% penalty (unless you meet one of the exceptions). These funds are the last in the ordering process, so you won’t be charged the penalty until you have distributed all of the non-penalized funds.