Is my Roth IRA Distribution Really Tax-Free?
Roth IRAs provide the unique opportunity to generate tax-free retirement wealth. You pay taxes on contributions, but earnings may be distributed without tax liability if you’re able to satisfy certain qualifications. Knowing the relationship between contributions and earnings will help you understand Roth distributions and can help you avoid unintended consequences. A non-qualified Roth distribution will be taxed as income and may be subject to an additional 10% penalty. To prevent incurring these expenses, make sure the following conditions exist before initiating a Roth IRA withdrawal:
- Contributions – You pay taxes on Roth contributions as if those funds are still in your pocket. Therefore, you won’t be taxed again if you withdraw those contributed funds, regardless of your age.
- You must be 59 ½ – Similar to a Traditional IRA, taxes and early distribution penalties will apply if Roth earnings are distributed prior to age 59 ½.
- Five-Year Rule – There’s a common misconception that a five-year-old Roth IRA may be fully distributed tax-free, but this is not always the case. Earnings may be distributed without tax liability after five years, but only on a first-in, first-out basis. Therefore, you may have opened your Roth IRA five years ago, but this doesn’t necessarily mean your full account is eligible for tax-free distribution.
To better understand these criteria, consider the following example:
- 2017, Age 45 – You open a new Roth IRA with the intention of purchasing a rental property. After transferring or rolling funds from other post-tax accounts, you learn that your closing costs will be slightly higher than what you have available. To close the gap, you make a $5,000.00 contribution.
- 2018, Age 46 – At the end of the year, your Roth IRA has earned $10,000.00 in rental income.
- 2019, Age 47 – Your IRA continues to collect rent payments, but you have a sudden need for cash on hand. You elect to distribute $5,000.00, which matches your 2017 contribution. As such, this is a qualified Roth distribution because you already paid taxes on those funds.
- 2020, Age 48 – You need to take another emergency distribution, so you withdraw an additional $5,000.00. You are not 59 ½, you’ve made no additional contributions, and your earliest earnings are only two years old. Therefore, this is a non-qualified Roth distribution.
- 2023, Age 51 – The $10,000.00 your Roth IRA earned in 2018 is now five years old. However, you’re still not 59 ½, so these funds may not be distributed tax-free.
- 2032, Age 60 – All rental income from 2018 through 2027 is at least five years old, and you’re now 59 ½. Therefore, you may begin distributing these funds without tax liability. You must wait until subsequent years to distribute any earnings yielded in 2028 or later.
Aside from the aforementioned requirements, other factors may alleviate your tax responsibility as well. If you’re permanently disabled or you’re buying your first home, you may be able to make Roth IRA withdrawals tax-free. To determine your eligibility and learn about proper reporting in these cases, please contact your accountant or tax professional. For general information about qualified Roth distributions, please don’t hesitate to contact our client relations team.
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