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When Is a Roth IRA Subject to Income Tax?

Elaine Roth
Elaine Roth (Photo credit: Wikipedia)

Ah, the Roth IRA. That single bastion of non-taxable money in our arsenal of accounts. When you have investments in a Roth IRA, you can take the money out tax-free, right? Not always.

There are several situations where a Roth IRA’s monies can be subjected to tax, penalty, or both.  Listed below are some of those circumstances.

When a Roth IRA is Taxable

It should be noted that contributions to a Roth IRA may always be withdrawn from the account tax-free, for any purpose whatsoever.  There are no restrictions on these withdrawals.

1.  Taking the money out of the account within the first five years of the account’s existence can result in taxation of a portion of the funds.  The portion that is taxable is any withdrawal that exceeds the total of all contributions and conversions into the account.  This rule applies without exceptions.

2.  If your Roth IRA has been in existence for the required five-year time, there are still some qualifications to meet in order to ensure that the withdrawals are completely tax free.  Specifically, you must

  • be at least 59½ years of age; OR
  • you must be disabled; OR
  • you must be taking no more than $10,000 more than the contribution and conversion amount(s) for a first-time home purchase; OR
  • the account owner has died.

If none of those qualifications applies, any amount greater than the conversion/contribution amounts will be subject to ordinary income taxation.

When a Roth IRA is Subject to Penalty

In addition to the specter of taxation, withdrawals from the Roth IRA could also be subject to a 10% early withdrawal penalty (much like a traditional IRA can be).  Here are a couple of cases when the 10% penalty may apply:

1.  Within five years of any conversion into a Roth IRA, if you take out amounts that include the converted funds, the withdrawal of the converted amounts will be subject to the 10% penalty. (unless one of the exceptions applies – see 19 Ways to Withdraw IRA Funds Without Penalty for more details)

2.  Even after the five year period has elapsed, if you are under age 59½ and none of the exceptions from #2 in the “Taxable” section above applies, any amount withdrawn that is greater than the conversions and contributions to the account will also be subject to the 10% penalty.

Wrap up

If the above is a bit confusing, you might need a refresher on the withdrawal sequence – how each dollar of withdrawal from a Roth IRA is attributed, and in what order.  Here’s how it goes:

First, all contributions to the account are withdrawn.  After that, all conversion amounts are withdrawn, starting with the amounts that have been converted for more than five years, and then subsequently any amounts that were converted less than five years ago (and therefore subject to penalty unless an exception applies).

After all conversions and contributions have been withdrawn, any growth in the account is withdrawn.  Growth occurs when the investments in the account gain in value or generate dividends and/or interest.  This money is taken out of the account last – and is the most likely to be both taxable and penalized if taken out before the stipulations above have been met.

For more detail on the withdrawal sequence, see the article Ordering Rules for Roth Distributions.

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7 Comments

  1. Kenny Allen says:

    I have a 401(k) with my previous employer that I am no longer contributing to. The account is 71% Roth and 29% pre-tax. I am wanting to use 10k for the a first-time home purchase.$8200 of the 10k would be from the Roth 401k .How would a rollover to an IRA or Roth IRA to avoid the most tax?
    Thanks.

    1. jblankenship says:

      If you rollover the entire 401(k) into an IRA and a Roth IRA, there would be no tax on the amount that you withdraw from the Roth IRA. You don’t have to take your withdrawal in proportion between the two accounts, so if you have $10k in Roth money, this withdrawal could be completely tax-free. Otherwise, whatever amount you withdraw from the regular (non-Roth) IRA would be added to your other taxable income for the year and taxed accordingly. If you’re under age 59 1/2, you’ll need to make sure you indicate that any non-Roth money was used for a first-time home purchase so that you’ll avoid the 10% early withdrawal penalty.

      1. Kenny Allen says:

        Thanks for the reply. Just so I understand, the IRA seasoning period of five years would not apply to the Roth IRA amount?

        1. jblankenship says:

          It does not, for the principal (your contributions, not the growth) if you’re under 59 1/2. If over 59 1/2 then the principal (your contributions) and the growth in the account would be available tax-free. Even if it did, you could make the withdrawal (principal only, not any growth) from the Roth 401(k) without penalty.

          1. Kenny Allen says:

            Thank you.

  2. Nancy Scovern says:

    “Within five years of any conversion into a Roth IRA, if you take out amounts that include the converted funds, the withdrawal of the converted amounts will be subject to the 10% penalty”. Is this true if the conversions happen after age 59 1/2? Thanks.

    1. jblankenship says:

      Hi Nancy –

      No, if the conversion happens after age 59 1/2 the five-year restriction does not apply.

      jb

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