Oblivious Investor

Mike’s note: In talking to people about Roth conversions, it has become clear to me that people have a lot of misunderstandings about the general rules for Roth IRA distributions. So today’s article is something of a back-to-basics post.

Types of Roth IRA Distributions

Withdrawals from a retirement account are known as “distributions.” The way a distribution from a Roth IRA is taxed depends on what type of money is being distributed. Specifically, a Roth IRA can consist of (up to) three types of money:

1. Contributions,
2. Amounts converted from a traditional IRA or other retirement plan, and
3. Earnings.

An important point to note here is that earnings are not considered to be “earnings on contributions” or “earnings on converted amounts.” They’re simply earnings.

Example: In Year 1 Kevin contributes $6,000 to a Roth IRA. In Year 2 Kevin contributes another $6,000 to the Roth IRA. He also converts $30,000 from his traditional IRA to his Roth IRA. At the end of Year 2, Kevin’s Roth IRA is worth $50,000. That $50,000 is considered to be a) $12,000 of contributions, b) $30,000 from conversions, and c) $8,000 of earnings. It does not matter whether the earnings are the result of growth from the converted amounts or growth from the contributed amounts. Earnings are simply earnings.

Another important point here is that distributions from a Roth IRA are considered to happen in the order listed above. That is, distributions are considered to first come from contributions, then from converted amounts, then from earnings.

Distributions of Contributions

The tax treatment of distributions of contributions is simple: contributions can come out at any time, tax-free and penalty-free.

Example: Kelly is 24 years old. She opens her first Roth IRA and contributes $3,000. Two weeks later, she takes the $3,000 back out. Kelly does not owe any tax or penalty.

Distributions of Converted Amounts

Distributions of converted amounts are not subject to ordinary income tax.

Distributions of converted amounts are subject to a 10% penalty, unless (at least) one of the following is true:

• The distribution is occurring at least 5 years from January 1 of the year in which the conversion occurred,
• The distribution is of a converted amount that was not taxable in the year of the conversion,
• The distribution is for a “qualifying reason” (listed below), or
• One of the “other exceptions” to the 10% penalty (also listed below) applies.

Distributions of converted amounts are considered to occur on a first-in-first-out basis. That is, if you do a Roth conversion in Year 1 and another in Year 2, distributions will be considered to come from the Year 1 conversion first. And for a given conversion, if it was partially taxable and partially nontaxable, the taxable portion (i.e., the portion of the conversion that was taxable in the year of conversion) is considered to be distributed before the nontaxable portion.

Qualifying Reasons

The following are the “qualifying reasons” for a distribution from a Roth IRA:

• You have reached age 59½.
• The distribution was made to your beneficiary after your death.
• You are disabled.
• You use the distribution to pay certain qualified first-time homebuyer amounts.

Other Exceptions to 10% Penalty

The following are the “other exceptions” to the 10% penalty:

• The distributions are part of a “series of substantially equal payments.”
• You have unreimbursed medical expenses that exceed 7.5% of your adjusted gross income.
• You are paying medical insurance premiums during a period of unemployment.
• The distributions are not more than your qualified higher education expenses.
• The distribution is due to an IRS levy of the account.
• The distribution is a qualified reservist distribution.
• The distribution is a qualified birth or adoption distribution (up to $5,000 per parent per birth/adoption).
• The distribution was a “qualified coronavirus-related distribution.”

Distributions of Earnings

Distributions of earnings will be subject to ordinary income tax unless they are “qualified distributions.” In order for a distribution to be a qualified distribution:

• It must be for a “qualifying reason” (listed above), and
• The distribution must not occur any earlier than 5 years from January 1 of the year in which you first established and contributed to a Roth IRA. (For example, if you first opened and contributed to a Roth IRA on May 18, 2019, this 5-year rule would be satisfied as of January 1, 2024.)

And distributions of earnings will be subject to a 10% penalty unless:

• The distribution is for a “qualifying reason” (listed above), or
• You meet one of the “other exceptions” to the 10% penalty (also listed above).

The following flowchart summarizes tax treatments of distributions of earnings from a Roth IRA:

All Roth IRAs Are Viewed as One

When applying the above rules, the IRS views all of your Roth IRAs together as one big Roth IRA. For example, distributions from a Roth IRA will not count as distributions of earnings until you’ve withdrawn an amount greater than the total of all of your contributions to all of your Roth IRAs.

Example: In 2018, you contributed $2,000 to a Roth. In 2019, you opened a Roth IRA with a different brokerage firm and contributed $3,000 to it. By 2021, each Roth has grown to $5,000. You could withdraw $5,000 from either (but not both) of the two Roth IRAs without having to pay taxes or penalties because your total contributions were $5,000 and because the IRS considers them to be one Roth IRA for these purposes.

What if You Have Rolled a Roth 401(k) or 403(b) into Your Roth IRA?

If you have rolled assets from a designated Roth account in an employer plan (i.e., what we would typically refer to as a Roth 401(k) or Roth 403(b)) into your Roth IRA, those rollover amounts are separated into contributions and earnings — and then lumped into the appropriate category along with regular Roth IRA contributions and earnings.

Of note: at least in theory, this information should be transmitted from the administrator of the employer plan to the administrator of the Roth IRA. But it’s best if you keep records of your own, to be able to demonstrate the portion of the rollover that is attributable to contributions.

Example: Over the course of a few years, you contribute $50,000 to your Roth 401(k). After leaving that employer, you roll the entire Roth 401(k), which is worth $80,000 at the time of the rollover, into your Roth IRA. For the sake of applying the distribution rules discussed above, the $50,000 is treated as if it were regular Roth IRA contributions (i.e., it can be withdrawn from the Roth IRA tax-free and penalty-free at any time). And the additional $30,000 will be treated just like any other earnings in the Roth IRA (i.e., it will be treated in keeping with the rules shown in the flowchart above).