When I first learned about Roth IRAs, I thought they were great. You contribute money after tax, let it grow, and then withdraw all the money tax-free. It sounded simple and appealing, but it’s actually more complex than that.
To gain a better understanding of Roth IRAs, it’s important to grasp a few basic rules.
Rule #1: The IRS considers all Roth IRA accounts as one account
No matter how many different Roth IRA accounts you have or their purposes, the IRS views them as a single account when it comes to taxation.
Rule #2: Your Roth IRA balances consist of contributions, conversions, and earnings
The IRS categorizes your “aggregate” account into three buckets: contributions, conversions, and earnings.
Understanding these buckets is crucial for comprehending the tax and penalty implications of a withdrawal. The IRS not only looks at your balance within these buckets but also follows a specific order of withdrawal. You first withdraw money from the contribution bucket, then from the conversion bucket, and finally from the earnings bucket.
Rule #3: Your Roth IRA withdrawals MAY be subject to tax and penalties
Refer to the chart below to gain a better understanding of the tax implications of a non-qualified Roth withdrawal.
| Balance category | Tax Implications |
| Contributions | Always tax and penalty-free |
| Conversions | Always tax-free, but may be subject to penalty |
| Earnings | May be subject to tax and penalty |
Is there a way to avoid this complexity? Yes, by ensuring that all your withdrawals are qualified. For a withdrawal to be considered qualified, it must meet two criteria: you must be over 59 1/2 years old, and you must have contributed to a Roth IRA at least five years before the withdrawal. The second criterion is critical. When it comes to a qualified withdrawal, you have a single 5-year clock for your “aggregate” Roth account, which starts on January 1st of the year you made your first deposit into a Roth IRA account.
Let’s consider an example. Suppose you opened a Roth IRA and deposited $1,000 on November 2nd, 2017. Your 5-year clock for qualified withdrawals starts on January 1st, 2017. Therefore, as of January 1st, 2022 (assuming you are over 59 1/2 years old), you have fulfilled the requirements for a qualified withdrawal. All funds in that account are eligible to be withdrawn without incurring taxes or penalties.
Why is this important?
Imagine you’re 65 years old and ready to retire. Let’s say you convert your Traditional IRA to a Roth IRA the following year when you’re 66. This is your first Roth IRA account. Despite being over 59 1/2 years old, you still need to wait five years before making penalty-free withdrawals from that conversion!
Consider another common scenario. You have a 401k at work that allows Roth contributions. After retiring, you decide to roll your Roth 401k balance into a Roth IRA (note that a Roth 401k and Roth IRA have separate 5-year clocks). Let’s assume this is your first Roth IRA account. Regardless of your age, any withdrawals made within the first five years may be subject to taxes and penalties.
How can you avoid this? By starting the clock. Ideally, you should open and fund a Roth IRA (even with a small balance) at age 55 or earlier. This will initiate the 5-year clock and ensure that once you turn 60, any withdrawals will be qualified, thus exempt from taxes and penalties. If you’re already past age 55, open and fund your Roth IRA as soon as possible. The longer you wait, the longer you’ll have to wait to meet the qualified distribution rules.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
