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People in need of cash may be considering an early withdrawal from their Roth IRA. Tax Guy discusses the tax consequences to consider.
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COVID-19-related financial distress may have you thinking about taking Roth IRA withdrawals to improve your cash situation. That’s something to ponder. But before pulling the trigger, please make sure you understand the federal income tax consequences, especially if you’re under 59½. This column explains what you need to know. Here goes.
Common misconceptions
You may think that any and all withdrawals from Roth IRAs are federal-income-tax-free. Sadly, that’s not true. Some withdrawals are taxable. And some withdrawals taken before age 59½, which we will call early withdrawals, can get hit with a 10% penalty tax to boot.
Here are the specifics on how Roth withdrawals are treated under the federal income tax rules.
Only qualified withdrawals are tax-free
Roth IRA withdrawals are tax-free qualified withdrawals if taken after:
1. You’re at least 59½ (or disabled or dead) and
2. You’ve had at least one Roth IRA open for over five years.
If you satisfy both conditions, any and all withdrawals from any and all Roth accounts set up in your name will be qualified withdrawals. As such, they are federal-income-tax-free and penalty-tax-free. However, you must pass both the age-59½ test and the five-year test to be eligible for qualified withdrawals.
Key point: For determining whether you pass the five-year test, the five-year period begins on January 1 of the first year for which you made a Roth contribution. It can be a regular annual contribution or a conversion contribution.
Nonqualified withdrawals fall under complicated rules
Any nonqualified withdrawal from a Roth IRA is potentially subject to federal income tax. In addition, early nonqualified withdrawals (taken before age 59½) are potentially subject to a 10% penalty tax on top of the income tax hit. You may also owe state income tax.
Nonqualified withdrawals most commonly occur in two scenarios:
* You take a withdrawal before age 59½ or
* You take a withdrawal before passing the five-year test.
As explained below, nonqualified withdrawals can potentially come from four different layers, and different tax rules apply to each layer. If you own several Roth IRAs, you must aggregate them and treat them as a single account for purposes of determining which layer(s) your withdrawals come from and the resulting federal income tax consequences.
Nonqualified withdrawals from Layer No. 1 (annual contributions)
When you take nonqualified withdrawals, they are treated as coming first from Layer No. 1, which consists of the total amount of your annual Roth contributions. Withdrawals from Layer No. 1 are always federal-income-tax-free and penalty-free.
To determine how much of your Roth IRA balance is in Layer No. 1, add up the total annual contributions to all Roth IRAs set up your name and subtract any withdrawals previously taken from Layer No. 1. Make this calculation on IRS Form 8606 (Nondeductible IRAs), and file it with your Form 1040.
Nonqualified withdrawals from Layer No. 2 (taxable portion of conversion contributions)
After you’ve exhausted Layer No. 1, any additional nonqualified withdrawals are treated as coming first from Layer No. 2, which consists of the taxable portion of any Roth conversion contributions you’ve made over the years.
Conversion contributions can come from converting a traditional IRA into a Roth account or from contributing a retirement plan distribution (like from a 401(k) account) to a Roth IRA. The taxable portion of a conversion contribution is the amount of taxable income triggered by that contribution.
To determine how much you have in Layer No. 2, review your tax returns and add up all the taxable conversion contributions to all Roth IRAs set up in your name. Then subtract any withdrawals previously taken from Layer No. 2. Make this calculation on Form 8606, and file it with your Form 1040.
Withdrawals from Layer No. 2 are always federal-income-tax-free.
However, they are not always penalty-tax-free. Unless you’re eligible for a tax-law exception, you’ll owe the 10% early withdrawal penalty tax on a nonqualified withdrawal taken from Layer No. 2 if: (1) you’re under age 59½ and (2) the withdrawal is taken within five years of the conversion contribution to which it relates. The five-year period starts on January 1 of the year during which you made the conversion contribution. If you made several conversion contributions, use the first-in-first-out (FIFO) principle to determine which conversion contribution each withdrawal comes from.
For exceptions to the 10% penalty tax, see this earlier Tax Guy column.
If you owe the 10% penalty tax, complete IRS Form 5329 (Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts), and file it with your Form 1040.
Nonqualified withdrawals from Layer No. 3 (nontaxable portion of conversion contributions)
After you’ve exhausted Layer No. 1 and Layer No. 2, any additional nonqualified withdrawals are treated as coming first from Layer No. 3, which consists of the nontaxable portion of any Roth conversion contributions. The nontaxable portion of a conversion contribution is the amount of nondeductible contributions included in that conversion contribution.
Withdrawals from Layer No. 3 are always federal-income-tax-free and penalty-tax-free.
To determine how much you have in Layer No. 3, review your tax returns and add up all the nontaxable conversion contributions to all Roth IRAs set up in your name. Then subtract any withdrawals previously taken from Layer No. 3. Make this calculation on Form 8606, and file it with your Form 1040.
Nonqualified withdrawals from Layer No. 4 (account earnings)
After you’ve exhausted Layers 1 through 3, any additional nonqualified withdrawals come from Layer No. 4, which consists of Roth IRA earnings.
Nonqualified withdrawals from Layer No. 4 are always 100% taxable.
You’ll also be hit with a 10% early withdrawal penalty tax on any amount withdrawn from Layer No. 4, unless you’re eligible for a tax-law exception. For exceptions to the 10% penalty tax, see my earlier column.
If you owe the 10% penalty tax, complete IRS Form 5329, and file it with your Form 1040.
Example
In 2016, you converted a traditional IRA with a balance of $100,000 into a Roth account. The entire $100,000 was a taxable conversion contribution (Layer No. 2), because you had not made any nondeductible contributions to the traditional IRA that you converted.
In 2018, you made a $5,000 annual contribution to your Roth IRA (Layer No. 1).
You only have the one Roth account, and you made no more contributions after 2018.
In 2020, you withdraw $125,000 to deal with COVID-19-created financial distress. At the time of the withdrawal, your Roth balance was $250,000, and you were under 59½.
The first $5,000 of the withdrawal is treated as coming from Layer No. 1 (from the 2018 annual contribution). The entire $5,000 comes out federal-income-tax-free and penalty-free.
The next $100,000 is treated as coming from Layer No. 2 (the 2016 taxable conversion contribution). The entire $100,000 comes out federal-income-tax-free. However, you’ll owe the 10% early withdrawal penalty tax on the entire $100,000, unless you’re eligible for a tax-law exception. Why? Because: (1) you took out the $100,000 within five years of 1/1/16 (the date you’re deemed to have made the taxable conversion contribution that constitutes Layer No. 2) and (2) you’re under 59½.
The final $20,000 comes from Layer No. 4 (account earnings). The entire $20,000 must be reported as income on your 2020 Form 1040. Because you were under 59½ on the withdrawal date, the entire $20,000 is also hit with the 10% early withdrawal penalty tax, unless you’re eligible for a tax-law exception.
Key point: See the sidebar below for special tax-favored treatment of so-called coronavirus-related distributions from Roth IRAs. If you qualify, you might want to take advantage of this special deal instead of taking a garden-variety Roth withdrawal that will fall under the less-favorable tax rules explained above.
The bottom line
As a general rule, you’re well-advised to leave Roth IRA balances untouched, so you can keep earning tax-free income and gains. Sometimes, however, that’s just not possible. This may be one of those times. As you can see from this column, the tax rules for Roth IRA withdrawals can be complicated. You might want to consult your tax advisor before pulling the trigger on any significant Roth IRA withdrawal.
SIDEBAR: Coronavirus-related distributions from Roth IRAs
Thanks to the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), you may be eligible to take a tax-favored coronavirus -related distribution in 2020 from one or more Roth IRAs or traditional IRAs set up in your name. To be eligible, you must have been adversely affected by the coronavirus pandemic. If you pass that test, you can take one or more coronavirus-related distributions in 2020, totaling up to $100,000, from your IRA(s). Subject to the $100,000 limit, such distributions are completely exempt from the 10% early withdrawal penalty tax.
Under complicated rules, you can recontribute a coronavirus-related distribution from a Roth IRA back into a Roth IRA within three years of when you received the distribution, and eventually avoid any federal income tax hit. Consult your tax pro if you think you might be eligible for this special deal and want to find out more.
