Tue. Oct 26th, 2021

Mike’s note: Speaking to people about Roth conversions, it’s become clear to me that people have a lot of misunderstandings about the general rules for Roth IRA distributions. So today’s article is a basic post.

Types of Roth IRA distributions

Withdrawals from a retirement account are known as “distributions.” How a distribution of a Roth IRA is taxed depends on the type of money being distributed. Specifically, a Roth IRA can consist of (up to) three types of money:

  1. Contributions,
  2. Converted amounts from a traditional IRA or other retirement plan and
  3. Earnings.

An important point to keep in mind here is that profits are no it is considered “gains on contributions” or “profits on converted amounts.” They are simply gains.

Example: In Year 1 Kevin contributes $ 6,000 to a Roth IRA. In Year 2, Kevin contributes another $ 6,000 to Roth’s IRA. He also converts $ 30,000 from his traditional IRA into his Roth IRA. At the end of the second year, Kevin’s Roth IRA is worth $ 50,000. These $ 50,000 are considered a) $ 12,000 in contributions, b) $ 30,000 for conversions, and c) $ 8,000 in earnings. It does not matter whether the profits are the result of the growth of the amounts converted or the growth of the amounts contributed. Earnings are simply gains.

Another important point here is that distributions of a Roth IRA are considered to occur in the above order. That is, distributions are considered to come first from contributions, then from converted amounts, and then from revenue.

Distributions of contributions

The tax treatment of the distributions of contributions is simple: the contributions can leave at any time, free of taxes and without penalties.

Example: Kelly is 24 years old. He opens his first Roth IRA and contributes $ 3,000. Two weeks later, the $ 3,000 is withdrawn. Kelly owes no tax or penalty.

Distributions of converted quantities

The distributions of the converted amounts are no subject to ordinary income tax.

Distributions of converted amounts they are subject to a penalty of 10%, unless (at least) one of the following is met:

  • The distribution occurs at least five years after January 1 of the year in which the conversion occurred,
  • The distribution is of a converted amount that was no taxable in the year of conversion,
  • Distribution is done for a “rating reason” (shown below), or
  • One of the “other exceptions” applies to the 10% penalty (also shown below).

Distributions of converted amounts are considered to occur according to the first input-output. That is, if you do a Roth conversion in year 1 and another in year 2, the distributions will be considered to come first from the conversion year 1. And for a given conversion, if it was partially taxable and partially non-taxable, the taxable part (i.e., the part of the conversion that was taxable in the year of conversion) is considered to be distributed before the non-taxable part.

Reasons for classification

The following are the “rating reasons” for a Roth IRA distribution:

  • You are 59 years old.
  • Distribution was made to your beneficiary after your death.
  • You are disabled.
  • Use the distribution to pay certain qualified amounts per first home buyer.

Other exceptions to the penalty of 10%

The following are the “other exceptions” to the 10% penalty:

  • Distributions are part of a “series of substantially equal payments.”
  • You have unreimbursed medical expenses that exceed 7.5% of your adjusted gross income.
  • You pay health insurance premiums during a period of unemployment.
  • Distributions do not exceed qualified higher education expenditures.
  • The distribution is due to an IRS tax on the account.
  • Distribution is a qualified reservist distribution.
  • Distribution is a qualified birth or adoption distribution (up to $ 5,000 per parent per birth / adoption).
  • The distribution was a “qualified coronavirus-related distribution.”

Earnings distributions

Distributions of earnings they will be subject to ordinary income tax unless they are qualified distributions. For a distribution to be a qualified distribution:

  • It must be for a “qualification reason” (mentioned above), i
  • Distribution must not occur before five years from January 1 of the year you first established and contributed to a Roth IRA. (For example, if you first opened and contributed to a Roth IRA on May 18, 2019, this five-year rule would be met as of January 1, 2024).

And profit distributions will be subject to a 10% penalty unless:

  • Distribution is made for a “qualification reason” (mentioned above), or
  • Know one of the “other exceptions” to the 10% penalty (also shown in the list above).

The following flow chart summarizes the tax treatments of the profit distributions of a Roth IRA:

All of Roth’s IRAs look like one

By applying the above rules, the IRS sees all of your Roth IRAs together as a great Roth IRA. For example, distributions of a Roth IRA will not be counted as profit distributions until you have withdrawn an amount greater than total of all your contributions to all your Roth IRAs.

Example: In 2018, you contributed $ 2,000 to Roth. In 2019, you opened a Roth IRA with another brokerage firm and contributed $ 3,000. By 2021, each Roth has grown to $ 5,000. You can withdraw $ 5,000 from either Roth IRA (but not both) without having to pay taxes or fines because total the contributions were $ 5,000 and because the IRS considers them to be a Roth IRA for this purpose.

What if you inserted a Roth 401 (k) or 403 (b) into your Roth IRA?

If you entered assets from a designated Roth account into a business plan (that is, what we would normally call Roth 401 (k) or Roth 403 (b)) in your Roth IRA, these transfer amounts are separated into contributions and gains – and then grouped into the appropriate category along with the regular contributions and gains of Roth IRA.

It should be noted: at least in theory, this information should be passed on from the business plan administrator to the Roth IRA administrator. But it’s best to keep your own records so you can demonstrate the part of the change that is attributed to contributions.

Example: Over the course of a few years, you will contribute $ 50,000 to your Roth 401 (k). After leaving this employer, enter the entire Roth 401 (k), which is worth $ 80,000 at the time of the change, into your Roth IRA. In order to enforce the distribution rules discussed above, the $ 50,000 is treated as if it were regular Roth IRA contributions (i.e., you can withdraw from the Roth IRA tax-free and penalty-free at any time). ). And the additional $ 30,000 will be treated the same as any other Roth IRA benefit (i.e., it will be treated according to the rules shown in the flow chart above).

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