Roth IRA Ordering Rules

Take-Away: There are strict ordering rules with regard to distributions from a Roth IRA, along with an aggregation rule that often creates some confusion when distributions are taken from a Roth IRA.

Roth Distribution Rules: Roth IRAs have strict ordering rules when it comes to distributions. Forget concepts like LIFO, FIFO, or pro rata. These Roth IRA ordering rules are straightforward:

1. Roth contributions are distributed first; after the contribution dollars are fully depleted,
2. Next to be distributed are converted dollars, i.e. Roth conversions; and after the Roth conversion dollars are fully depleted, then
3. Earnings on the Roth account are distributed to the Roth owner.

Aggregation Rule: The IRS treats the entirety of an individual’s Roth IRAs, regardless of the number of Roth IRAs owned, as a single Roth IRA. Consequently, it does not matter from which Roth IRA the owner takes a distribution; the IRS looks at all of the owner’s Roth accounts as a single retirement account, internally divided into: (1) contributions; (ii) conversions; and (iii) accumulated income.

Why Important?: A Roth IRA owner can always withdraw Roth IRA funds, without any question. The question is whether the Roth IRA distribution will be subject to the 10% early withdrawal penalty, or income taxes. Recall that there must be a 5-year wait before income from a Roth IRA can be withdrawn without any income tax consequences. As a quick summary of the basic distribution rules follow:

Contributions: Roth contributions are always available tax and penalty-free to the Roth IRA owner, regardless of how long the Roth IRA was opened, or the Roth owner’s age. Accordingly, if a distribution is made from a Roth IRA to its owner, these contributions come out first, both penalty and income tax-free.

Conversions: Since income taxes were paid for the year of the Roth IRA conversion, these conversion dollars also come out to the Roth IRA owner tax-free. Roth IRA conversion dollars are penalty-free after 5 years, or age 59 ½. Note that if either the 5-year or age 59 ½ requirement is satisfied, then the conversion dollars are accessible by the Roth IRA owner free of penalty.

Earnings: The earnings on a Roth IRA are available to be distributed to the Roth IRA owner both tax and penalty-free if made (i) after 5 years; and (ii) after the Roth owner attains age 59 ½. Both conditions must be satisfied to avoid taxation and penalty.

Conclusion: Suffice it to say, the IRS keeps track of an individual’s Roth IRA contributions, their Roth IRA conversions, and the earnings in those Roth IRA accounts. If the IRS is ‘keeping score’ then it is important to follow these distribution rules to avoid unnecessary penalties and income taxes.