A Roth IRA's biggest appeal is the tax-free withdrawals it promises in retirement. It could save you a fortune compared to deferring taxes if you expect your income to remain roughly the same or rise after leaving the workforce.
But some don't realize that tax-free withdrawals aren't a guarantee. In some situations, you could owe taxes on your Roth IRA funds if you're not careful. Here's what you need to know to avoid this.
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When does the government tax Roth IRA funds?
You pay taxes on your Roth IRA contributions in the year you make them. This is different from traditional IRA contributions, which reduce your taxable income for the year. Because you pay taxes upfront, your Roth IRA contributions are always yours to use as you wish. You can take this money out at any time and you won't pay taxes or penalties on these withdrawals.
But the same can't be said for Roth IRA conversions or earnings. Roth IRA conversions happen if you change money from a traditional IRA or 401(k) to Roth savings at some point. When you do this, you'll pay taxes on the converted amount that year. However, this doesn't give you the right to access your converted funds immediately.
The IRS has a five-year rule that prevents you from withdrawing converted funds tax-free for five years after the conversion. But the countdown begins on Jan. 1 of the year the conversion took place. So if you converted some traditional IRA funds to a Roth IRA on Dec. 31, 2024, you could access them tax- and penalty-free as early as Jan. 1, 2029. Each conversion has its own five-year clock.
There's a similar rule for Roth IRA earnings. You aren't permitted to withdraw earnings tax-free until you've had the account for at least five years. Again, the countdown begins on Jan. 1 of the year you made your first contribution.
Failure to follow the above rules could result in taxes on your Roth IRA conversions or earnings. You could also owe taxes, plus a 10% early withdrawal penalty, if you withdraw earnings while you're younger than 59 1/2, even if you've had your Roth IRA for more than five years at the time.
What if you have Roth IRA contributions, conversions, and earnings in your account?
The IRS has another rule that determines how it classifies your withdrawals. Contributions always come out first, then conversions, then earnings. So say you have $10,000 in a Roth IRA -- $5,000 from contributions, $3,000 from conversions, and $2,000 from earnings. If you took a $4,000 withdrawal, it would all be considered contributions and you wouldn't owe taxes or penalties on anything.
If you withdrew $6,000 from your account, $5,000 of that would be considered contributions and would be tax- and penalty-free. But the final $1,000 would be considered converted funds. If you haven't met the five-year rule, you could owe taxes on that $1,000.
Finally, if you withdraw $9,000, the first $5,000 would again be considered contributions. The next $3,000 would be considered conversions, and the final $1,000 would come from earnings.
How do you avoid Roth IRA taxes and penalties?
The best way to avoid Roth IRA taxes and penalties is to simply leave your money in your account until you're at least 59 1/2 and have had your account for at least five years. If you have to withdraw money earlier, try to limit yourself to just your personal contributions. Your plan administrator can help you figure out the total value of your contributions if you're not sure.
If you need to withdraw earnings, you may be able to avoid the 10% early withdrawal penalty if you have a qualifying reason, like using the money for:
- Qualifying educational or medical expenses
- A first-time home purchase (up to a lifetime maximum of $10,000)
- Your living expenses after becoming disabled
- Birth or adoption expenses (up to $5,000 per child)
- Expenses following a federally declared disaster
However, even if you have a qualifying reason, you'll still owe taxes on your withdrawn earnings if you're under 59 1/2.
It's best to explore other ways to cover your expenses before making a withdrawal from your Roth IRA. If you decide to go ahead with it, be sure to update your retirement plan. You may need to save more going forward or delay retirement to meet your original retirement goal.
