Take-Away: Simple rules need to be following to avoid paying taxes, or possibly a penalty, when distributions are taken from a Roth IRA.

Background: Almost every financial or estate planning article these days encourages individuals to convert their traditional IRA to a Roth IRA. The reasons for that advice are straightforward. Current tax brackets are wide and income tax rates are relatively low after the 2017 Tax Act. With a ‘down’ market, there are fewer income taxes to pay on the conversion of a traditional IRA to a Roth IRA. The benefits of a Roth IRA are well known. There are no required minimum distributions (RMDs) are from a Roth IRA in retirement years. There is no exposure to creditor claims at the  state level and in bankruptcy for a Roth IRA.  And, usually, there no income taxes on distributions from a Roth IRA. However, the tax-free Roth IRA distributions require that the account owner follow a few simple steps to assure that the distributions  from the Roth IRA are tax-free. If Roth IRA funds are needed due to cash flow problems in our currently turbulent economy, consider the following rules.

  1. Aggregate All Roth IRAs: For income tax purposes, all Roth IRAs of the account owner are deemed consolidated as a single Roth IRA account. Accordingly, there is no tax benefit to be derived from keeping Roth conversions in a Roth IRA account, separate from regular Roth IRA contributions. All Roth accounts are all aggregated to determine whether income taxes will be imposed on a Roth IRA distribution.
  1. Favorable Ordering Rules for Distributions: Distributions from a Roth IRA are subject to favorable ordering rules in which the distributed funds are classified: (i) Contributed amounts come our first -these are after-tax dollars that were contributed to the Roth IRA account, so they remain tax-free; (ii) retirement funds that were converted to the Roth IRA are distributed next- these are also tax-free dollars, since income taxes were paid on the conversion; and finally (iii) earnings/gains on the funds held in the Roth account are distributed last from the Roth IRA- these earnings may, or may not, be taxable.
  1. Roth Contributions are Tax/Penalty-Free: The Roth contributions which are distributed first from the account are always tax-free and penalty-free. Accordingly, if funds are needed by the account owner, they are readily available without any tax or penalty consequence, regardless of the account owner’s age and regardless of how long the Roth IRA has been open.
  1. 10% Penalty on Converted Roth Funds: While converted Roth funds are always distributed income tax-free, those converted funds may still be subject to the 10% early distribution penalty if (i) the Roth IRA owner is under the age 59 ½ at the time of the distribution and (ii) the conversion was less than 5 years earlier. This 5-year Roth duration rule re-starts separately for each conversion the account owner makes. If the Roth IRA account owner is over the age 59 ½ when the converted funds, but not Roth earnings, are taken from the Roth IRA, there is no problem with the 5-year duration rule.
  2. Qualified Distributions of Earnings: The earnings generated  by a Roth IRA are not subject to income tax if the distribution meets the definition of a qualified distribution. A distribution from the Roth IRA is qualified if it is made after the account owner has owned any Roth IRA for a period of 5 years and the account owner is over the age 59 ½, is disabled, is taking the funds for a first-time home purchase, or the account owner dies.

This last rule creates some confusion. The 5-year period for a qualified distribution is not the same as the 5-year period for penalty-free distributions of converted funds held in the Roth IRA. The 5-year rule that pertains to qualified distributions does not re-start with each Roth IRA contribution or Roth conversion.

Example: Betty opens a Roth IRA on July 1, 2017. Betty contributes $100 to her Roth IRA on that July 1, 2017. In 2020, Betty inherits funds and she decides to use those inherited funds to convert her traditional IRA to her Roth IRA. After that Roth conversion, Betty now has $1.0 million in her Roth IRA.  On January 1, 2022, all of the funds held in Betty’s Roth IRA would be considered to have been held for 5 years for purposes of determining a qualified distribution of Betty’s Roth IRA’s earnings. Betty’s 5-year period began on January 1, 2017, even though she did not make her first contribution to her Roth IRA (of $100) until July 1, 2017.

This last 5-year rule is often why individuals are encouraged to open a Roth IRA as early as possible, even when only a nominal amount is contributed to the Roth IRA, in order to start the 5-year-clock running.

Conclusion: These Roth distribution rules are not overly complex, although the two 5-year rules can cause a bit of confusion. The most important thing to remember is that Roth contributions will always come out first, and they will always be tax and penalty-free, regardless of how long the Roth account has been open.