Greetings! I trust that this finds you well and enjoying life.
Last week I wrote about distributions from traditional IRAs. This week let’s examine the particulars of withdrawing from Roth IRAs.
You are free to make withdrawals at any time from your Roth IRA, but only qualified distributions receive tax-free treatment. A qualified distribution is not subject to federal income tax or a 10 percent premature distribution tax. A withdrawal from a Roth IRA (including both your contributions and investment earnings) is qualified if: (1) it’s made at least five years after you first establish any Roth IRA, and (2) any one of the following also applies:
• You have reached age 59 ½ by the time of the withdrawal.
• The withdrawal is made due to a qualifying disability.
• The withdrawal is made for first time homebuyer expenses ($10,000 lifetime limit).
• The withdrawal is made by your beneficiary or estate after your death.
The five-year holding period begins on January 1 of the tax year for which you make your first regular contribution to any Roth IRA or, if earlier, January 1 of the tax year in which you make your first rollover contribution to any Roth IRA. Because the five-year holding period runs from the first day of the plan year in which you establish any Roth IRA, you should establish one as soon as you can, even if you can afford only a minimal contribution. The earlier you satisfy the five-year holding period, the sooner you may be able to receive tax-free qualified distributions from your Roth IRA.
Even if you make a withdrawal that fails to meet the requirements for a qualified distribution, your Roth IRA withdrawal enjoys special tax treatment. When you withdraw funds from your Roth IRA, distributions are treated as consisting of your contributions first and investment earnings last. Since amounts that represent your contributions have already been taxed, they are not taxed again or penalized (even if you are under age 59 ½) when you withdraw them. Only the portion of a nonqualified distribution that represents investment earnings will be taxed and possibly penalized. All of your Roth IRAs are aggregated when determining the taxable portion of your nonqualified distribution.
Example(s): In 2014, you establish your first Roth IRA and contribute $5,000 in after-tax dollars. You make no further contribution to the Roth IRA. In 2016 your Roth IRA has grown to $5,300. You withdraw the entire $5,300. Because you withdraw the funds within five tax years, your withdrawal does not meet the requirements for a qualified distribution. You already paid tax on the $5,000 you contributed, so that portion of your withdrawal is not taxed or penalized. However, the $300 that represents investment earnings is subject to tax and the 10 percent premature distribution tax, unless an exception applies.
Distributions from Roth IRAs are generally treated as being made from contributions first and earnings last (see ordering rules below). In the previous example, if you withdrew only $5,000 (leaving $300), the withdrawal would be tax free (and penalty free) since the entire amount would be considered a return of your contributions.
Technically, a distribution from a Roth IRA that is not a qualified distribution and is not rolled over to another Roth IRA is included in your gross income to the extent that the distribution, when added to the amount of any prior distributions (qualified or nonqualified) from any of your Roth IRAs, and reduced by the amount of those prior distributions that were previously included in your gross income, exceeds your contributions to all your Roth IRAs. For this purpose any amount distributed to you as a corrective distribution is treated as if it was never contributed.
The IRS requires you to take your annual RMDs from traditional IRAs beginning at age 70 ½. These withdrawals are calculated to dispose of all the money in the traditional IRA over a given period of time. However, Roth IRAs are not subject to the RMD rules. In fact, you are not required to take a single distribution from a Roth IRA during your life. This can be a significant advantage in terms of your estate planning.
If we can help in any way with this or anything else related to retirement don’t hesitate to contact us.
Jeff Christian CFP, CRPC