The biggest advantage that Roth IRAs have over other types of retirement savings vehicles is that making contributions to a Roth offers the chance later in life to take tax-free withdrawals from your nest egg in retirement. However, although it's relatively easy to get tax-free treatment for Roth withdrawals, there are a few situations in which you can end up paying taxes when you take money out of a Roth. In some cases, all or part of the money you withdraw will be added to your taxable income, while in others, you might owe a penalty for taking a withdrawal.
Most Roth withdrawals are not taxable
In general, you don't have to include Roth IRA withdrawals in taxable income in two instances. First, if the distributions are qualified under IRS rules, then they're tax-free. Also, even if the distributions aren't qualified, they're still tax-free to the extent that they represent a return of the contributions that you made.
Qualified distributions include any withdrawal from your Roth that meets both of the following requirements:
- The withdrawal takes place after the end of the five-year period that started during the first tax year for which you made a Roth contribution.
- The withdrawal either occurs after you turn 59 1/2 or qualifies for exceptions to the general rule, including withdrawals made due to disability, for a first-home purchase, or to a beneficiary of the account after your death.
Therefore, as long as you've had a Roth long enough and are taking withdrawals in retirement, you'll usually be set with a qualified withdrawal that is tax-free and penalty-free.
Dealing with potentially taxable Roth withdrawals
However, even if your distribution isn't qualified, it still might not get taxed. Withdrawals are treated as coming first from the contributions that you made to the Roth. Those distributions aren't subject to income tax, and the 10% penalty doesn't apply even if you take them out before reaching age 59 1/2.
Once you've taken out all of your contributions, withdrawals of the earnings that the Roth has generated are potentially subject to tax and penalties. However, a wider range of exceptions to the 10% penalty can prevent you from having to pay it in certain circumstances. For instance, withdrawals that go toward unreimbursed medical expenses exceeding 10% of adjusted gross income, medical insurance premiums during a period of unemployment, higher education expenses, or a series of substantially equal payments all qualify for an exception to the 10% penalty rules. You'll still have to include the withdrawals as income on your tax return because they're not qualified, but at least it eases the penalty burden.
Where things get particularly tricky is with Roth conversions from other types of retirement accounts. There, a separate five-year rule applies to each conversion. Take withdrawals before five years pass after a Roth conversion, and you'll owe the 10% penalty even if you'd otherwise be old enough to avoid it. To the extent that you included the converted amount in taxable income when you did the conversion, you don't have to include that money again as income when you withdraw it, and the ordering rules treat you as having taken the already-taxed portion before the untaxed portion. However, the application of the separate five-year rule complicates matters, making it far easier to wait and rely on the qualified distribution rules.
Be smart with your Roth
Roth IRAs are one of the only ways that retirement savers can enjoy truly tax-free income. However, you have to be careful to take advantage of the rules correctly in order to avoid taking distributions that should be free of tax and instead transforming them into taxable events. If you keep these rules in mind, you should be able to ensure that you'll have full access to your Roth IRA money without having the tax man lying in wait for a share of your hard-earned retirement savings.
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