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How To Avoid Bad Surprises In Roth IRAs
If you've been tempted to contribute to a Roth IRA, or to convert some or all of the funds in your traditional IRAs into a Roth, it's likely you've been influenced by the lure of future tax-free payouts. However, be aware this tax-favored treatment isn't automatic, by any means. What's more, if you're below a certain age limit, you may be slapped with a tax penalty on top of the regular income tax you'll owe.
At the same time, though, even if the Roth IRA distributions are subject to tax, the impact may be negligible or nonexistent under special IRS "ordering rules." That means that even "taxable" Roth distributions may be effectively tax-free.
Here are the basic rules for Roth IRAs. You don't get any tax break now for contributing to a Roth. But "qualified" distributions from a Roth IRA that has been established for at least five years are 100% exempt from federal income tax. For this purpose, qualified distributions include those made:
- After you reach age 59 ½;
- Because of death or disability; or
- To pay for qualified homebuyer expenses (up to a lifetime limit of $10,000).
The rule that often trips people up is the one requiring the Roth IRA to be in existence for at least five years. To compound matters, if you withdraw funds before five years have elapsed and you're under the magic age of 59 ??, you'll have to pay a 10% penalty on the distribution amount.
But here’s the silver lining: Under IRS rules, the money you take from a Roth IRA is treated as being distributed in the following order:
1. Roth IRA contributions. That money went in without any tax advantage to you, and you can take it out, for whatever reason, without any penalty or taxes.
2. Contributions made when you converted a traditional IRA into Roth status. These may be withdrawn tax-free even if they are part of a nonqualified distribution, but the 10% penalty tax generally applies to withdrawals within five years, unless you're age 59 ?? or older.
3. Contributions made when you converted nontaxable traditional IRA balances into Roth IRA status. Such contributions also may be withdrawn on a tax-free basis subject to the 10% penalty.
4. Earnings within the Roth IRA. These amounts are taxable when withdrawn unless they meet the definition of qualified distributions. In addition, the 10% penalty tax applies to withdrawals made before age 59 ??.
As you can see, federal income tax on a distribution doesn't kick in until you've gone through the first three categories. For many people with a sizable amount in a Roth, distributions won't be taxable at all, even if funds are withdrawn within five years of setting up the account.