The Tax Rules for Roth IRA Withdrawals

In a recent meeting with a client, they had two big, unexpected expenses come up – they needed a new car, and their daughter was getting married! They were concerned about how these expenses would affect their taxes. Fortunately, they have had some money saved in a Roth IRA that they withdrew from tax-free to help mitigate the tax burden of withdrawing all that money from a pre-tax IRA.

The Roth IRA is one of the most powerful tools in your retirement planning arsenal. Its tax advantages during the accumulation phase are well-known, but understanding the rules for Roth withdrawals is equally crucial.

 The Golden Rule: Over age 59 ½ and open for 5 years:

If you are over 59 ½ AND your Roth IRA has been open and funded for more than 5 years ago, you can withdraw any amount from your Roth IRA tax and penalty-free. For this reason, one common tax trick is to open a Roth IRA and contribute or convert a small amount ($50 for example) so you can start the 5-year clock.

Contributions: Always tax and penalty-free

Any amount you contribute to a Roth IRA can be tax and penalty-free at any age.

For example, if you contribute $5,000 to a Roth IRA and it grows to $8,000, you can withdraw $5,000 without any taxes or penalties. The $3,000 in growth is subject to the age and 5-year clock to determine if it is tax and penalty-free.

Conversions:

Roth conversion amounts follow the five-year clock, and withdrawals of earnings before age 59½ may incur taxes and penalties. For example, a 50-year-old who converts $20,000 to a Roth IRA that grows to $30,000 over 5 years may withdraw that $20,000 after 5 years but must leave the $10,000 of growth in the Roth IRA until they reach age 59 ½.

If you are over 59 1/2, you can withdraw the conversion immediately without taxes, but the earnings cannot be withdrawn without taxes until 5 years have passed since you first funded a Roth IRA. For example, a 60-year-old funds a Roth IRA for the first time by converting $20,000 to a Roth IRA that grows to $30,000 over 3 years. They may withdraw that $20,000 but must leave the $10,000 of growth in the Roth IRA until 5 years have passed or else subject that $10,000 to taxes.

 Special Situations:

There are special situations where the rules can be waived such as a first-time home purchase, education expenses, and more.

 No RMDs:

Unlike traditional IRAs that have required minimum distributions (RMDs), Roth IRAs have no such mandate during the account owner's lifetime, allowing you to leave this money growing tax-free for your entire life.

By understanding these various Roth IRA withdrawal rules, this account can provide a fantastic source of tax diversification and flexibility in retirement.

Happy Planning,

Alex

This blog post is not advice. Please read disclaimers.