If you’re experiencing financial distress during the COVID-19 crisis, you might be thinking about tapping into your Roth IRA to improve your cash situation. But before withdrawing money from a Roth account, it’s important to understand the federal income tax consequences, especially if you’re under 59½.
You may think that all withdrawals from Roth IRAs are federal-income-tax-free. Unfortunately, that’s not true. Some withdrawals are taxable. On top of that, some early withdrawals (taken before you turn 59½) can potentially get hit with a 10% penalty tax.
Only qualified Roth IRA withdrawals are federal-income-tax-free. To be eligible for tax-free treatment, you must:
- Be at least 59½ (or dead or disabled), and
- Have had at least one Roth IRA open for over five years.
The five-year period for determining if you pass the five-year test begins on January 1 of the first tax year for which you make a Roth contribution. It can be a regular annual contribution or a conversion contribution.
If both conditions are satisfied, all withdrawals from any Roth account set up in your name will be qualified withdrawals. As such, they are federal-income-tax-free and penalty-tax-free.
Complex Rules for Nonqualified Withdrawals
Any nonqualified withdrawal from a Roth IRA is potentially subject to federal income tax. In addition, early nonqualified withdrawals are potentially subject to a 10% penalty tax on top of the income tax hit. You may also owe state income tax.
Nonqualified withdrawals most commonly occur in two scenarios:
1. You take a withdrawal before age 59½, or
2. You take a withdrawal before passing the five-year test.
Nonqualified withdrawals are handled under a four-layer system. (See “4 Layers of Nonqualified Withdrawals” below.) If you own several Roth IRAs, you must aggregate them and treat them as a single account to determine which layer(s) each nonqualified withdrawal comes from and the resulting federal income tax consequences.
Exceptions for Certain Early Withdrawals
Any Roth withdrawal taken before you turn 59½ is, by definition, a nonqualified withdrawal, unless you’re:
- Dead, or
- Eligible for the special first-time homebuyer rule.
To be eligible for the first-time homebuyer rule, you must first pass the five-year test. In addition, you must spend the amount you’ve withdrawn within 120 days to pay qualified principal residence acquisition costs. However, there’s a $10,000 lifetime limit on this special rule. To the extent the special rule applies to your Roth withdrawal, the qualified amount is free from federal income tax and free from the 10% early withdrawal penalty tax.
The principal residence can be purchased by:
- The Roth account owner,
- The Roth account owner’s spouse, child, grandchild or grandparent, or
- A child, grandchild or grandparent of the Roth account owner’s spouse.
The homebuyer (and the buyer’s spouse if the buyer is married) must not have owned a principal residence within the two-year period that ends on the acquisition date. Qualified acquisition costs are defined as those spent to acquire, construct or reconstruct a principal residence, including closing costs.
Any Roth IRA withdrawal taken before age 59½ that doesn’t fall within one of the preceding exceptions is a nonqualified withdrawal and is taxed under the four-layer system. (See “4 Layers of Nonqualified Roth IRA Withdrawals” below.)
Coronavirus-Related Roth IRA Distributions
Thanks to the Coronavirus Aid, Relief and Economic Security (CARES) Act, you may qualify to take a tax-favored coronavirus-related distribution from a Roth IRA in 2020 only. To be eligible, you must be considered to have been adversely affected by the pandemic.
An eligible individual can take one or more coronavirus-related distributions from one or more Roth IRAs set up in his or her name, totaling up to $100,000. Subject to the $100,000 limit, such distributions are completely exempt from the 10% early withdrawal penalty tax.
Under complicated rules, you can recontribute a coronavirus-related distribution back into a Roth IRA within three years of when the distribution was received — and eventually avoid any federal income tax hit.
4 Layers of Nonqualified Roth IRA Withdrawals
Nonqualified Roth IRA withdrawals can occur for two reasons:
1. The account owner isn’t yet 59½ and isn’t dead or disabled, or
2. The account owner fails the five-year test.
If you made several conversion contributions, you must use the first-in-first-out (FIFO) principle to determine which conversion contribution each withdrawal comes from for purposes of determining if you pass the five-year test for that withdrawal.
Nonqualified Roth withdrawals can potentially come from four different layers and different federal income tax rules apply to each layer. If you own several Roth IRAs, you must aggregate them and treat them as a single account for purposes of determining which layer(s) withdrawals come from and the resulting tax consequences.
Important: If your spouse owns one or more Roth IRAs in his or her own name, that doesn’t affect how withdrawals from your Roth IRA(s) are taxed.
When you take nonqualified withdrawals, they’re treated as coming from these four layers in the following order:
1. Annual Contributions
The first layer consists of the total annual contributions to all Roth IRAs set up in your name, less any withdrawals from this layer taken in previous years. Withdrawals from this layer are always federal-income-tax-free and penalty-free.
2. Taxable Portion of Conversion Contributions
After you’ve exhausted the first layer, any additional nonqualified withdrawals are treated as coming from the second layer, which consists of the taxable portion of any Roth conversion contributions you’ve made over the years. Conversion contributions can come from converting a traditional IRA into a Roth account or from contributing a retirement plan distribution — for example, from a 401(k) account — to a Roth IRA. The taxable portion of a conversion contribution is the amount of taxable income triggered by that contribution.
To determine how much you have in the second layer, review your tax returns and add up all the taxable conversion contributions to all Roth IRAs set up in your name. Then subtract any withdrawals taken from this layer in previous years.
Withdrawals from the second layer are always federal-income-tax-free. However, they aren’t always penalty-tax-free. Unless you’re eligible for a tax-law exception, you’ll owe the 10% penalty tax on a nonqualified withdrawal taken from this layer if:
- You’re under 59½, and
- The withdrawal is taken within five years of the conversion contribution to which it relates.
Ask your tax advisor about the tax-law exceptions. The five-year period starts on January 1 of the year during which you made the conversion contribution. If you made several conversion contributions, use the FIFO principle to determine which conversion contribution each withdrawal comes from.
3. Nontaxable Portion of Conversion Contributions
After you’ve exhausted the first two layers, any additional nonqualified withdrawals are treated as coming from the third layer, which consists of the nontaxable portion of any Roth conversion contributions. The nontaxable portion of a conversion contribution is the amount of nondeductible contributions included in that contribution. Withdrawals from this layer are always federal-income-tax-free and penalty-tax-free.
To determine how much you have in this layer, review your tax returns and add up all the nontaxable conversion contributions to all Roth IRAs set up in your name. Then subtract any withdrawals taken from this layer in previous years.
4. Account Earnings
After you’ve exhausted the first three layers, any additional nonqualified withdrawals come from the fourth layer, which consists of cumulative Roth IRA earnings. Nonqualified withdrawals from this layer are always 100% taxable. Plus, you’ll be hit with a 10% early withdrawal penalty tax on any amount withdrawn from this layer, unless you’re eligible for a tax-law exception.
Example: Tax Impact of Early Withdrawal
Here’s an example of how these layers might come into play. In 2016, Tom converted a traditional IRA worth $90,000 into a Roth account. The entire $90,000 was a taxable conversion contribution (layer 2), because Tom hadn’t made any nondeductible contributions to the traditional IRA. In 2018, Tom made a $5,000 annual contribution to the Roth IRA (layer 1). This is his only Roth IRA, and he made no more contributions after 2018.
In July 2020, at age 45, Tom decided to withdraw $105,000 to deal with coronavirus-related financial distress. At the time of the withdrawal, his Roth balance was $150,000. What are the tax implications of Tom’s withdrawal?
- The first $5,000 of the withdrawal is treated as coming from layer 1 (the 2018 annual contribution). The amount is federal-income-tax-free and penalty-free.
- The next $90,000 is treated as coming from layer 2 (the 2016 taxable conversion contribution). The entire $90,000 comes out federal-income-tax-free. However, Tom will owe the 10% penalty tax on the entire $90,000, unless he’s eligible for a tax-law exception. Why? First, he took out the $90,000 within five years of December 1, 2016 (the date he’s deemed to have made the taxable conversion contribution that constitutes layer 2). Additionally, Tom wasn’t yet 59½ as of the withdrawal date.
- The last $10,000 comes from layer 4 (account earnings). The entire $10,000 must be reported as gross income on Tom’s 2020 federal income tax return. In addition, because Tom was under 59½ on the withdrawal date, the entire $10,000 will be hit with the 10% penalty tax, unless he’s eligible for a tax-law exception.
Important: For the first $100,000 of his 2020 withdrawal, Tom might qualify for the special tax-favored treatment for coronavirus-related Roth IRA distributions. (See main article.) Your tax advisor can provide more details on this limited-time opportunity.
As a general rule, you’re well-advised to leave Roth IRA balances untouched, so you can keep earning tax-free income and gains. Sometimes, however, that’s not possible. Contact us today to discuss the complex tax rules before making any significant Roth IRA withdrawal.