Roth IRA accounts are a popular way to save and invest for retirement. These IRAs offer attractive features such as tax-free distributions and a variety of investing options. Roth IRAs are funded with post-tax dollars and do not have required minimum distributions. The primary downside of a Roth IRA is the $6,000 annual contribution limit (this limit is $7,000 for those over 50) and, for some, the lack of tax deferral to reduce taxable income.
Rules About Roth IRA Distributions
The IRS has very specific rules about withdrawing funds from retirement accounts, including the Roth IRA. Roth IRA distributions are considered qualified if you are over 59 1/2 or if the reason for the distribution fits the IRS allowances. Unqualified distributions may be subject to tax plus a 10 percent penalty. Remember, there is a five-year rule for Roth IRAs which means that you must have held the account for at least five years in order to withdraw tax-free distributions.
You can withdraw from your Roth IRA basis tax-free at any time. Also, you can contribute to your Roth IRA without an age limit, and there are no required minimum distributions for a Roth IRA, but you might have to pay taxes on earnings, according to brokerage Charles Schwab. Roth IRAs follow a first-in-first-out rule, meaning that withdrawals are ordered based on your direct contributions first, then conversion contributions and finally earnings, per the tax firm H&R Block.
Are Roth IRA Distributions Taxable?
Nonqualified distributions from a Roth IRA may be taxable. Distributions may also be subject to a 10 percent penalty in addition to taxes on the full taxable amount of the distribution. Typically, Roth IRA distributions are taxable if they are withdrawn before the account owner turns 59 1/2.
Any tax will be assessed at your ordinary income tax rate. You will know whether the distribution is qualified or subject to tax and penalties based on the distribution code in box 7 of your 1099-R. States may also assess taxes or penalties.
If the account is less than five years old, both taxes and penalties will be due – unless you have a valid reason for the distribution to avoid the penalties. Valid reasons for an early Roth IRA distribution include education expenses, medical expenses over 7.5 percent of your adjusted gross income, first-time home purchases, birth or adoption fees or disability. Refer to the IRS for the full list of acceptable withdrawals.
If the account is over five years old, then the taxes are avoidable as well with a valid reason. If you are over 59 1/2 and your Roth IRA is less than five years old, your distributions will be subject to taxes.
Reporting Roth IRA Distributions
Sometimes, distributions from a Roth IRA may be taxable as income on a Form 1040 or 1040-SR tax form. You will use IRS Form 8606 to determine the taxable portion of the Roth distribution. The amount determined to be taxable will then go on your Form 1040 (or 1040-SR) on line 4B for "Retirement Distributions."
If the distribution is subject to a penalty, it will go on Form 5329. If there is an exception to the penalty, it will also go on Form 5329. You will also use Form 5329 to report any additional annual contributions over the $6,000 ($7,000 if you are over 50) limit. Follow the directions on each form regarding where to plug in the amounts on Form 1040 or 1040-SR. Be sure to include any withholdings from the distribution that are indicated on the 1099-R.
If you made a Roth IRA distribution due to the coronavirus, the CARES Act treats this as a qualified disaster retirement plan distribution. This distribution will go on Form 8915-E. Any penalty will be waived and the tax will be repayable across a three-year period to ease the burden of your tax liability. Of course, the tax can also be paid in its entirety for the year of distribution.
Hashaw Elkins is a financial services and tax professional, as well as a project management consultant. She has led projects across multiple industries and sectors, ranging from the Fortune Global 500 to international nongovernmental organizations. Hashaw holds an MBA in Real Estate and an MSci in Project Management. She is further certified in organizational change management, diversity management, and cross-cultural mediation.