Distributions from a Roth IRA: The Five Year Plan

Q: Tax Playa, I would like to make a distribution from my Roth IRA.  Will any of this be taxable or penalized in any way?
Doug, Bethesda MD

A: Doug, as a general rule, premature withdrawals of earnings are the only Roth IRA funds that are taxed or penalized.  However, there are aggregating, ordering, and five-year rules to watch out for...

For more information on Roth IRA distributions, please consult IRS Publication 590, Individual Retirement Arrangements (IRAs).

A Roth IRA is designed so that inflows are from after-tax dollars.  The money compounds tax-free for retirement, and in retirement is a tax-free distribution.

With a few limited exceptions (detailed in my posting to the right on IRAs and Roth IRAs), no early distributions are allowed (being defined as prior to the year in which you turn 59 and 1/2).

This is fairly-straightforward for Traditional IRAs, but one has a basis in contributions to a Roth IRA due to their after-tax nature.  So, if you want to make a distribution from a Roth IRA that is:

1. early (prior to age 59 and 1/2), and
2. not a qualified early exception (like first home, education, medical, etc.)

you need to go through a three-step process to see if any part of your distribution is taxable.

Step One: Aggregation

This is a simple one.  If you own several Roth IRAs, you need to treat them all as one, giant Roth IRA for the purposes of this calculation.  As a side note, there is really no purpose in having more than one.  You may as well consolidate them with an inexpensive brokerage firm.

Step Two: Ordering

Once money gets into your Roth IRA, it's all fungible.  Therefore, there are arbitrary "ordering" rules that allow you to distinguish the three sources of Roth IRA funds.  The three types of funds and the order in which you are deemed to remove them are:

1. Contributions.  Because of aggregation, count all original contributions to all Roth IRAs.  Contributions are never, ever taxable or penalized.
2. Conversions.  If you converted a Traditional IRA to a Roth IRA, these come out next.  These come out on a first-in-first-out basis, so the oldest conversions are the first out.  These may or may not be penalized (see the five-year rule below), but are never taxed (since they are after-tax dollars).
3. Earnings.  These are always taxable (because they haven't been taxed yet) and penalized if they are early and/or non-qualified.

Step Three: Five Year Rule

If you have taken out an early and/or non-qualifying distribution, and have burned through all of your original contributions to Roth IRAs, you are probably taking out converted amounts next.  There is a special rule for basis in converted funds.  Any money that is put into a Roth IRA because of a Roth conversion takes five tax years for you to vest your basis in.

For instance, suppose you are taking out conversion money you converted on February 1, 2002.  Because it is less than five years from January 1, 2002 (the start of that tax year), you don't have full basis in this money.

Do you have to pay income tax on the distribution?  No--you already did that when you converted the money in the first place.  However, not passing the five-year test means you must pay a 10% penalty on the distributed money.

Incidentally, the five-year rule also applies to licit distributions from a Roth IRA, but with a twist: whereas the clock for the five year rule for conversion distributions starts from January 1st of the year of that conversion, the clock for the five year rule for licit Roth IRA contributions starts from January 1st of the first tax year you had a Roth IRA at all.  This is a subtle but very important distinction.