O Is For Ordering Rules.
Roth individual retirement accounts (Roth IRAs) have been around for a relatively short period of time. Specifically, Roth IRAs were part of the Taxpayer Relief Act of 1997, signed into law under President Clinton. They’re still fairly new, so the rules aren’t all that familiar to many taxpayers.
Unlike traditional IRAs, you can’t take a tax deduction for contributions made to a Roth IRA; this is because Roth IRAs are funded with after-tax dollars. The big upside, however, is that distributions from Roth IRAs are generally tax-free so long as you follow the rules.
The rules are fairly simple. To qualify for a tax-free distribution, the withdrawal must be made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA (the so-called “5-year rule”) and also:
- Made on or after the date you reach age 59½;
- Made because you are disabled (you must be able to furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition and your condition must be expected to result in death or to be of long, continued, and indefinite duration);
- Made to a beneficiary or to your estate after your death; or
- Used to acquire a first home for yourself, your spouse or the child, grandchild or ancestor of you or your spouse (up to a $10,000 lifetime limit).
Withdrawals that meet that criteria are sometimes called “qualifying distributions.”
Even if you don’t meet the criteria for a “qualifying distribution,” you may still be able to withdraw funds from your Roth IRA, both tax and penalty-free. This is because the IRS has a set of ordering rules that govern how the funds in your Roth IRA must be withdrawn. The IRS requires that you order the distributions as follows:
- Regular (or principal) contributions.
- Conversion and rollover contributions, on a first-in, first-out basis.
- Earnings on contributions.
Regular, or principal, contributions come out first. That works to your advantage since they are funded with after-tax dollars. That means you can withdraw those funds without paying additional income tax or the 10% early withdrawal penalty.
Conversions and rollovers are next. If you’ve ever only funded a Roth IRA with principal contributions, then this piece doesn’t apply to you. But if you’ve taken advantage of conversion and rollover rules, then under the ordering rules, those are said to come out next – on a first-in, first-out basis. Those are exactly like they sound: those conversions are rollovers made in earlier years are said to be withdrawn first and you take contributions in chronological order afterward. Since there may be taxable and nontaxable pieces of your conversions and rollovers, the IRS deems the first withdrawals as those with a taxable portion followed by the nontaxable portion.
The last bit of funds to be withdrawn under the ordering rules are the returns on investments or earnings on contributions. Think about those as “everything else” in your Roth IRA.
For example, let’s say that you funded your Roth IRA with $10,000 and never performed a rollover or conversion. Let’s also say that in ten years, the Roth IRA has grown to $15,000. And let’s say that you take out the whole thing. Under the ordering rules, the $10,000 of principal is withdrawn first and the $5,000 of growth is withdrawn last. If you don’t meet any of the criteria for a qualified distribution (which is why you’re checking out the ordering rules to begin with), that withdrawal may be subject to income tax. The first $10,000 – the principal – comes out tax-free. But the last $5,000 – the growth – is subject to federal income tax and the 10% extra tax for early withdrawals.
Using that example, you can see that if you really have to make an early withdrawal from your Roth, paying attention to the ordering rules can save you some tax dollars. The rules can be tricky (especially the exceptions) so keep good records and rely on your financial and tax professionals to help you answer specific tax and investment questions.
