Now that we have discussed contributions, conversions, and qualified distributions, we will now look at the distribution ordering rules and penalties on "early" withdrawals from a Roth IRA.
IRS Ordering Rules
The IRS does not care from which Roth IRA you take a withdrawal. If you have multiple IRAs, they are considered as one Roth IRA for withdrawal purposes. Further, the IRS has deemed that Roth IRA distributions MUST be withdrawn in a specific order, and that order applies regardless of which Roth IRA is used to take that distribution. Roth distributions should be made in the following order:
- From non-taxable annual contributions to a Roth IRA (other than conversion amounts)
- From conversion contributions, on a first-in, first-out (FIFO) basis
- From earnings
Who cares? You might -- especially if you find that you have to take an early withdrawal. Let's look at some examples.
Penalties on Earnings from Contributions
Unless an exception applies, most distributions from a Roth IRA before the owner reaches age 59 1/2 will be subject to an "early withdrawal penalty" of 10% on the amount of the distribution. Be very careful NOT to confuse the early withdrawal penalty with the taxes imposed on a non-qualified distribution (discussed in Part III). A non-qualified distribution imposes an ordinary income tax on the distribution, but the early withdrawal penalty will be imposed in addition to that tax.
Jim, age 30, made a Roth IRA contribution of $2,000 in 1998. In 2005, Jim's Roth IRA has a balance of $3,500. Jim decides to close his Roth IRA in a non-qualified distribution that year. Since the distribution is non-qualified, Jim will owe taxes on his Roth earnings of $1,500, and will pay tax on this amount at his marginal tax rate. In addition, since the distribution took place before Jim reached age 59 1/2, and since Jim did not meet any of the exceptions, Jim will also be assessed a 10% early withdrawal penalty on the earnings. If we assume that Jim is in the 28% marginal tax bracket, he will pay $420 in tax on the earnings, and will pay a penalty in the amount of $150 on the early distribution. This is a very steep price to pay.
The early withdrawal penalty does not apply to distributions that:
- Occur because of the IRA owner's disability. (This can be a very narrow definition, so if you get a severe paper cut, don't consider a Roth IRA distribution for a disability until you review IRS Code Section 72(m)(7) and IRS Publication 590.)
- Occur because of the IRA owner's death.
- Are a series of "substantially equal periodic payments" made over the life expectancy of the IRA owner.
- Are used to pay for unreimbursed medical expenses that exceed 7 1/2% of adjusted gross income (AGI).
- Are used to pay medical insurance premiums after the IRA owner has received unemployment compensation for more than 12 weeks.
- Are used to pay the costs of a first-time home purchase (subject to a lifetime limit of $10,000).
- Are used to pay for the qualified expenses of higher education for the IRA owner and/or eligible family members.
- Are used to pay back taxes because of an Internal Revenue Service levy placed against the IRA.
Penalties on Conversions From a Traditional IRA to a Roth IRA
The penalty rules regarding conversions are a bit different than those for annual contributions, which may be taken at any time for any purpose free of income taxes and penalty. An early withdrawal of a conversion contribution has a different twist. The early withdrawal penalty applies to a distribution of conversion money from a Roth IRA when:
- The distribution is made within the five-tax-year period starting with the year that the conversion was distributed from a regular IRA; and
- Only to the extent that the distribution is attributable to amounts that were includable in gross income as a result of the conversion.
Paul made a $20,000 conversion from his regular IRA to a Roth IRA in 1998. The entire amount converted was includable in Paul's income for 1998. Paul made no additional contributions or conversions to a Roth IRA in 1998 or in later years. In 2001, before he is age 59 1/2, Paul withdraws $10,000 from the Roth IRA. Paul will have no tax to pay on this withdrawal because he paid income taxes on the full $20,000 he converted in 1998; however, he WILL have to pay a 10% penalty (or $1,000) unless one of the IRA early withdrawal exceptions apply. Why? Because Paul didn't keep the conversion amount in his Roth IRA for the required five-tax-year period since his original conversion.
So, if you are going to take funds "early" from your Roth IRA, weigh your conversion decision very carefully -- especially if you made non-deductible contributions to your original IRA. If you did make non-deductible contributions to your regular IRA, you'll generally be worse off by converting to a Roth IRA and taking the funds early than you would be by simply taking the funds from the regular IRA.
Why? Because a pro rata part of all withdrawals from a regular IRA are treated as coming out of non-deductible contributions. But, amounts withdrawn from Roth IRA conversions are treated as coming out of income taken into account on the conversion first.
Not quite clear on how this works? Let's take a look at an example:
Karin has a traditional IRA with a balance of $12,000 -- $6,000 of that IRA balance was from prior-year deductible contributions and total IRA earnings. The other $6,000 represents prior-year non-deductible contributions. Karin is contemplating a Roth IRA conversion, but also wants to take a distribution of $4,000. Karin's options are as follows:
- She can leave her money in the traditional IRA and take the $4,000 distribution. She'll be taxed on half of the distribution ($2,000) because half of the account is deductible contributions and earnings. She'll also pay a 10% penalty, but only on the $2,000 taxable distribution. The other $2,000 is tax- and penalty-free since it came from prior non-deductible contributions to the IRA.
- She can convert the entire traditional IRA to a Roth IRA and then take the $4,000 distribution. This is a bad choice for Karin. Once Karin takes the $4,000 distribution, she'll be subject to a 10% penalty on the entire distribution, or $400, because of the ordering rules. She won't have to pay any tax on the distribution (since the tax was paid when she converted the traditional IRA to the Roth IRA), but making this choice causes Karin to pay an additional $200 in penalties that could have been avoided with proper planning.
On the other hand, if you are reasonably young (under age 50) and expect to need to withdraw funds from your IRA in five years (and can't use any exceptions to avoid the 10% penalty), you might be better off converting funds from your regular IRA to a Roth IRA now. If you wait until after the five-tax-year period to withdraw money from a Roth IRA, the 10% penalty won't be imposed, even if you aren't yet 59 1/2 and don't meet any other exception to the penalty.
Why? Because, for a Roth IRA, you have met the five tax-year exception on the converted funds and therefore dodge the 10% penalty on these distributions. But, there is no five-tax-year exception for a traditional IRA. So, while you would still pay tax on the earnings in either case, you would escape the 10% penalty by converting to a Roth IRA.
Still not clear on this? Another example might be in order.
Rick converted $15,000 from his traditional IRA to a Roth IRA in 1999, and another $20,000 from a second traditional IRA in 2003. These conversions were all taxable to Rick when they occurred because he had made no non-deductible contributions to his traditional IRAs. He has no other Roth IRAs and he has not made any additional contributions to this Roth IRA since the original conversions.
In 2006, when Rick is still under age 59 1/2, he takes a distribution of $15,000. Is this distribution subject to tax? Nope, since the taxes were paid on these funds at the time of the conversion from the traditional IRA to the Roth IRA. Is this distribution subject to the 10% penalty? Nope again, because Rick held the conversion funds in the Roth IRA account for longer than the required five-tax-year period.
But what if Rick took a distribution of $20,000 in 2007? In that case, he would still receive $15,000 of that distribution tax- and penalty-free because it has been more than five tax-years since his first conversion of $15,000. But the second IRA was converted less than five tax-years ago. Therefore, the remaining $5,000 of his $20,000 distribution will be penalized 10% for an early withdrawal because he has not yet met the five-tax-year rule to tap into the second conversion contribution of $20,000. And when he takes that sum, he will have only $15,000 of conversion money left before he begins to take earnings from that Roth IRA.
As you can see, the tax-planning implications on Roth IRA withdrawals are numerous -- too numerous to mention here. Different tax and penalty rules can apply to distributions coming from contributions, conversions, or earnings.
Not only that, the rules regarding the 10% penalty on "early" (less than five tax-years) distributions relative to conversion amounts are determined for each conversion, and might not necessarily be the same five-tax-year period that you use to determine if a distribution is "qualified" for income tax purposes.
And, the penalty rules are different for conversions than they are for earnings from contributions. It can be a real mess.
If your Roth IRA consists of only contributions or only conversions, these rules aren't too difficult to follow. But if your Roth IRA consists of contributions, conversions in different years, and earnings on both, then the "qualified" distribution rules and the penalty rules can get very complex.
So, you really need to know the tax impact of your decision prior to removing any of your Roth IRA funds -- you can't just guess. Guessing could be hazardous to your wealth.
Your best bet? Keep your paws off your Roth IRA account unless your distribution is qualified and you meet one of the penalty exceptions. It'll make your tax life much easier.