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Roth IRA Distributions AREN’T Always Tax-Free

Posted in Tax by Mark Cussen
March 31, 2008 10:13 PM - 2 Comments

Typically most Roth IRA distributions are tax-free. But there are a few exceptions to this rule, one of which can apply even after you have reached age 59 ½. While these exceptions are not very common, Roth IRA owners should be aware of them and when they apply.

The first (and most common) exception occurs when a Roth distribution is taken after age 59 ½, and the earnings within the account are included in the distribution. A mandatory 5-year holding period applies for all income and gains realized inside a Roth IRA. Suppose you contribute $4,000 each year into your Roth IRA for four years. Over that time, the account earns an additional $4,000, bringing the total account balance to $20,000. Even if you are 59 ½ or older, if you withdraw the entire account balance at once, then the $4,000 of earnings will be taxed as ordinary income. However, if you wait another year, then those earnings will be tax-free as well. This five-year holding period only applies once for each Roth IRA account that is opened. The 10% early withdrawal penalty will additionally apply for any withdrawal of earnings taken before age 59 ½.

Earnings are also taxable for virtually all other exceptions to the early withdrawal penalty, such as death or disability. There are, in fact, no exceptions to the five-year rule, regardless of age or reason for withdrawal. The following table quantifies the rules for taxation of earnings from Roth IRAs:

Taxation of Roth IRA distributions.Roth IRA Earnings Withdrawn Roth IRA Earnings Withdrawn Within the First 5 Years After 5 Years

Distribution Purpose Are Earnings Taxable? Will the 10% Penalty Apply? Are Earnings Taxable? Will the 10% Penalty Apply?
On or Before Age 59 ½ Yes No No No
Before Age 59 ½, See Penalty Exception 1-7 Yes Yes Yes Yes
Death Yes No No No
Disability Yes No No No
1st Time Homebuyer, $10K limit Yes No No No
Equal Periodic Payments (72t) Yes No Yes No
Medical Expenses Above 7.5% AGI Yes No Yes No
Insurance Premiums by Unemployed Yes No Yes No
Higher Education Expenses Yes No Yes No
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  1. walker said:
    on August 24th at 02:49 am

    what if the early withdrawal is less than the original contribution? would that amount be taxable or subject to penalty?

  2. Mark P. Cussen, CFP, CMFC said:
    on August 24th at 02:53 am

    No, it would not. Only withdrawals in excess of total contributions are taxed and penalized.

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