What Should I Know About Taking Distributions From My Roth IRA?
What should I know about taking distributions from my Roth IRA?
Given the changes to Traditional IRA distribution requirements for non-spouse beneficiaries upon bequest, Roth IRAs are often looked at as long-term, legacy vehicles due to their favorable tax treatment for beneficiaries. That said, a Roth IRA has tremendous benefits for the account owner while living too. Withdrawals from a Roth IRA can be taken without paying taxes or penalties as long as you adhere to some rules set by the IRS. One of the most important rules is the 5-year rule, stipulating that you must wait five tax years (typically April 15) after your first Roth IRA contribution to take a distribution and avoid taxes or penalties. If you meet the 5-year rule and are over the age of 59.5, are disabled, or use distributions from a Roth IRA for a first-home, the distributions are deemed qualified and thus avoid taxes or penalties.
If you don’t meet the conditions of a qualified Roth distribution, your non-qualified distributions are taxed based on the source of the funds. The order in which contributions and earnings are considered to be withdrawn follows the IRS rules below:
- Regular Contributions
- Conversion and rollover contributions, treated on a first-in, first-out (FIFO) basis
This means that principal contributions will be distributed before any earnings. Your contributions are available to you at any time with no restrictions, taxes, or penalties whatsoever. A withdrawal of earnings from a Roth IRA is subjected to income taxes and potentially a penalty if deemed non-qualified.
In the eyes of the IRS, if you have multiple Roth IRA accounts, they all count as one, so if you opened a Roth IRA and started contributing to it more than five years ago, each of your Roth accounts are deemed to have met the requirement.
What about withdrawing Conversions from a Roth IRA?
The 5-Year Rule applies to converted funds from a Traditional IRA to a Roth IRA as well. For each conversion of funds, you will have to follow the 5-year rule. The main difference with conversions is that they follow a calendar year schedule. Any conversion made during the calendar year will be counted as if it was made on January 1 of that year.
Additionally, each conversion is subject to the 5-Year Rule. This does not get the same treatment as the standard Roth IRA 5-Year Rule that starts the 5-Year Rule from the first contribution. You must wait five years from each conversion made in order to withdraw penalty- and tax-free.
Roth Conversions also require that you must be age 59.5 or you will be subject to income tax and a possible penalty of 10%.
Does the 5-Year Rule apply to Inherited Roth IRAs?
It does apply. As long as the Roth had been open for at least five years at the time of the Roth owner’s death, contributions and earnings can be withdrawn immediately without taxes or penalties. If the account hadn’t been open for five years by the time the owner passes, the inheritor can withdraw contributions tax- and penalty-free but will pay taxes on earnings withdrawn. If the Roth IRA had been open for four years when the owner passes, the inheritor can simply wait one extra year (to hit the five year mark) and then withdraw contributions and earnings penalty- and tax-free.
The SECURE Act removed required minimum distributions from inherited IRAs and Roth IRAs, but now requires all funds be distributed within 10 years of inheritance (spouses exempt). Therefore, the 5-Year Rule could be more of an issue given this expedited timeline. Some inheritors plan to defer withdrawing from an Inherited Roth IRA until the tenth year to benefit from 10 additional years of tax-free growth.
Are there exceptions to the 5-Year Rule?
You may take tax-free distributions from your Roth IRA at any time and at any age for the following reasons:
- A down payment on your first home (capped at $10,000)
- Withdrawal to pay for higher education for yourself, your spouse, your children or grandchildren (capped at $10,000)
- Paying for health insurance premiums
- If you become unemployed
- Paying for medical expenses that exceed 10% of your adjusted gross income
For more information or to better understand how these requirements might affect you, please contact your advisor at Heck Capital.
Authored by Michael Bogard, CFA on January 28th, 2021.
About the Author: Michael Bogard, CFA is a Business Development / Client Relationships Senior Associate at Heck Capital Advisors. Michael earned the right to use the Chartered Financial Analyst® (CFA®) designation after completing the program, fulfilling the work experience requirements, and gaining acceptance as a member of the CFA Institute. The Chartered Financial Analyst® (CFA®) charter gives a strong understanding of advanced investment analysis and real-world portfolio management skills. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.
Heck Capital is an independent, Registered Investment Advisory Firm providing comprehensive investment management, personalized advice, and strategic financial guidance since the 1950s. We serve goal-driven individuals, families, established institutions, non-profit organizations, and foundations/endowments; striving to help our clients achieve their investment objectives, helping to simplify their financial lives, with the goal to create lasting legacies.