Michael Moffa, AIF®, AWMA®, CEPA®, CRPC®
Chairman | Private Wealth Advisor
You may think that all Roth IRA withdrawals are federal-income-tax-free. Not true! Some withdrawals are taxable.
Even worse, some can be socked with a 10 percent early withdrawal penalty tax, and this can happen even when there’s no income tax hit.
Here’s what you need to know about Roth IRA withdrawals under the federal income tax rules. We start with the simplest case.
Rules for Qualified Withdrawals Are Simple
Any withdrawals from any of your Roth accounts are federal-income-tax-free qualified withdrawals if you, as a Roth IRA owner,
are age 59 1/2 or older, and
have had at least one Roth IRA open for over five years.
Such withdrawals are usually state-income-tax-free too. Good!
You must pass both the age and the five-year tests to have a qualified withdrawal.1
The five-year period for determining whether your withdrawals are qualified starts on January 1 of the first tax year for which you make a Roth contribution.2 It can be a regular annual contribution or a conversion contribution.
Example 1. Figuring the earliest date for qualified withdrawals.
You established your initial Roth IRA (Roth IRA-1) with a regular annual contribution made on April 15, 2018, for your 2017 tax year. Your five-year period started on January 1, 2017, even though you physically made your initial Roth contribution in 2018.
Anytime on or after January 1, 2022, you can take federal-income-tax-free qualified withdrawals from Roth IRA-1, assuming you are age 59 1/2 or older on the withdrawal date.
You opened up a second Roth account (Roth IRA-2) in 2020 with a conversion contribution from a traditional IRA.
You can take tax-free qualified withdrawals from Roth IRA-1 and/or Roth IRA-2 anytime on or after January 1, 2022, assuming you are age 59 1/2 or older on the withdrawal date.
Tax Reporting for Qualified Withdrawals
When you take a qualified Roth withdrawal, you should receive a Form 1099-R from the IRA trustee or custodian.3
Box 1 of the Form 1099-R should report the gross amount of the withdrawal.
Usually, box 2b will be checked to indicate that the trustee or custodian has not determined the taxable amount (if any). But if the trustee or custodian knows the withdrawal was a qualified withdrawal, box 2a should report a taxable amount of zero and box 7 should contain distribution code Q (qualified distribution, meaning it’s tax-free).
You enter the total amount of the qualified withdrawal on line 4a of your Form 1040.4 Enter zero on line 4b, because qualified withdrawals are federal-income-tax-free. Simple!
Rules for Non-Qualified Withdrawals Are Not So Simple
A non-qualified withdrawal is potentially subject to federal income tax. In addition, non- qualified withdrawals taken before age 59 1/2 are potentially subject to a 10 percent early withdrawal penalty tax.5
To make things a bit easier to understand, we will break down non-qualified withdrawals into two scenarios:
Withdrawals that are non-qualified because they are taken before age 59 1/2.
Withdrawals that are non-qualified solely because they are taken before you’ve passed the five-year test.
Scenario 1: Withdrawal Is Non-Qualified because You Take It before Age 59 1/2
In general, any Roth withdrawal taken before you have reached age 59 1/2 is a non-qualified withdrawal by definition. The only exceptions are:
when the special first-time home purchase provision (explained later) applies, or
when the account owner (that would be you) is disabled or dead.
A non-qualified withdrawal is potentially subject to both federal income tax and the 10 percent early withdrawal penalty tax.
Non-qualified withdrawals can potentially come from four different layers. Different federal income tax rules apply to each layer.
Key point. If you have several Roth IRAs, you must aggregate them and treat them as a single account to determine which layer or layers each withdrawal comes from and the resulting federal income tax consequences.6
Withdrawals from Layer No. 1 (Annual Contributions)
Non-qualified withdrawals are deemed to come first from the layer consisting of annual Roth contributions, which we will call Layer No. 1. Withdrawals from this layer are always federal- income-tax-free and penalty-free. (Remember, this is the money you put into the Roth, not the earnings of the Roth.)
To determine how much is in Layer No. 1, combine the annual contributions to all Roth IRAs set up in your name.
To prove that you owe no federal income tax or early withdrawal penalty tax on a non-qualified withdrawal from Layer No. 1, complete Part III of IRS Form 8606 Nondeductible IRAs, and include it with your Form 1040.7
Enter the total amount of the withdrawal on line 4a of your Form 1040.8 Enter zero on line 4b, because withdrawals from Layer No. 1 are always federal-income-tax-free.
Withdrawals from Layer No. 2 (Taxable Portion of Conversion Contributions)
After you’ve exhausted Layer No. 1, additional non-qualified withdrawals are deemed to come from the layer consisting of the taxable portion of any Roth conversion contributions, which we will call Layer No. 2.
Conversion contributions can come from converting a traditional IRA into a Roth account or from contributing a retirement plan distribution, such as from a 401(k) account, to a Roth IRA. The taxable portion of a conversion contribution is the amount of gross income that was triggered by the conversion contribution (the total contribution amount minus any non-deductible contributions included in that contribution).
To determine how much is in Layer No. 2, combine all the taxable conversion contributions to all Roth IRAs set up in your name.
While withdrawals from Layer No. 2 are always federal-income-tax-free, you could still get hit with the 10 percent early withdrawal penalty tax. Specifically, the 10 percent penalty tax hits any amount withdrawn from Layer No. 2 within five years of the conversion contribution unless one of the penalty tax exceptions for IRAs is available.
The five-year period is deemed to begin on January 1 of the year during which you made the conversion contribution.9
If you made several conversion contributions in different years, use the first-in-first-out (FIFO) principle to determine which contribution the withdrawal comes from for purposes of applying the five-year rule.10
To prove that no federal income tax is owed on a non-qualified withdrawal from Layer No. 2, complete Part III of IRS Form 8606 and include it with your Form 1040.11 If you owe the 10 percent early withdrawal penalty tax, complete IRS Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, and include it with your Form 1040.12 Enter the penalty tax amount on the appropriate line of Form 1040.
Enter the total amount of the withdrawal on line 4a of your Form 1040. Enter zero on line 4b, because withdrawals from Layer No. 2 are always federal-income-tax-free even though they may be exposed to the 10 percent early withdrawal penalty tax.
Withdrawals from Layer No. 3 (Non-Taxable Portion of Conversion Contributions)
After you’ve exhausted Layer No. 1 and Layer No. 2, additional non-qualified withdrawals are deemed to come from the layer consisting of the non-taxable portion of any Roth conversion contributions, which we will call Layer No. 3.
The non-taxable portion of a conversion contribution equals the amount of non-deductible contributions included in that conversion. To determine how much is in Layer No. 3, combine all the non-taxable conversion contribution amounts to all Roth IRAs set up in your name.
Withdrawals from Layer No. 3 are always federal-income-tax-free and penalty-tax-free.
To prove that no federal income tax is owed on a non-qualified withdrawal from Layer No. 3, complete Part III of IRS Form 8606, and include the form with your Form 1040.13
Enter the total amount of the withdrawal on line 4a of your Form 1040. Enter zero on line 4b, because withdrawals from Layer No. 3 are federal-income-tax-free.
Withdrawals from Layer No. 4 (Account Earnings)
Any additional non-qualified withdrawals come from the layer consisting of Roth IRA earnings, which we will call Layer No. 4.
Non-qualified withdrawals from Layer No. 4 are always 100 percent taxable. Complete Part III of IRS Form 8606, and enter the taxable amount from Layer No. 4 on Line 4b of your Form 1040.14
In addition, you’ll owe the 10 percent early withdrawal penalty tax on non-qualified withdrawals taken from Layer No. 4 unless one of the exceptions to the penalty tax for IRAs is available.15
If you owe the 10 percent early withdrawal penalty tax, complete IRS Form 5329 and include it with your Form 1040.16 Enter the penalty tax amount on the appropriate line of your Form 1040.
Enter the total amount of the withdrawal on line 4a of your Form 1040. Enter the same amount on line 4b, because withdrawals from Layer No. 4 are always taxable.
Example 2. Handling an early Roth IRA withdrawal.
You are currently under age 59 1/2. Back in 2017, you converted your only traditional IRA, which was then worth $60,000, into a Roth IRA. Assume the entire $60,000 was a taxable conversion contribution because you claimed a tax deduction for all the money you put into this IRA.
In April 2019, you made a $5,000 annual contribution to the same Roth account. That contribution was for your 2018 tax year. You have not made any further Roth IRA contributions.
In 2021, you withdraw $30,000. At the time of the withdrawal, your Roth account balance was
$100,000. The withdrawal is a non-qualified withdrawal because you are under age 59 1/2.
Under the layering rules for non-qualified withdrawals, the first $5,000 is treated as coming from your annual contribution for the 2018 tax year (Layer No. 1). That amount is federal- income-tax-free and penalty-free.
The remaining $25,000 is treated as coming from the 2017 conversion contribution (Layer No. 2). The $25,000 is federal-income-tax-free. But because the $25,000 was withdrawn within five years of the deemed conversion contribution date (January 1, 2017), it’s hit with the 10 percent early withdrawal penalty tax unless you are eligible for one of the exceptions to the penalty tax for IRAs.
Key point. Withdrawing from Layer No. 2 within five years of the deemed conversion contribution date is a less-than-great idea unless you are eligible for an exception to the 10 percent early withdrawal penalty tax.
Example 3. Both income tax and penalty tax can potentially apply to early Roth withdrawals.
Assume the same basic facts as in Example 2, except this time you withdraw $70,000 in 2021.
As in Example 2, the first $5,000 is deemed to be a federal-income-tax-free and penalty-free withdrawal from Layer No. 1.
The next $60,000 is deemed to come from Layer No. 2. The $60,000 comes out federal- income-tax-free, but you owe the 10 percent early withdrawal penalty tax on the entire
$60,000 unless you are eligible for an exception.
The final $5,000 comes from account earnings (Layer No. 4). The entire $5,000 must be reported as taxable income on your 2021 Form 1040 because you are not age 59 1/2, dead, disabled, or using the money for qualified home acquisition costs (see below).
The entire $5,000 is also hit with the 10 percent early withdrawal penalty tax unless you are eligible for an exception.
Scenario 2: Withdrawal Is Non-Qualified because You Fail the Five-Year Test
Any Roth withdrawal taken after you have reached age 59 1/2 (or died or become disabled) but before you pass the five-year test is a non-qualified withdrawal by definition. As such, it’s potentially subject to federal income tax and the 10 percent early withdrawal penalty tax.
In Scenario 2, where you fail the five-year test, non-qualified withdrawals are handled under the same four-layer system that applies to Scenario 1 non-qualified withdrawals.
Key point. In this failed-the-five-year-test scenario, you are never hit with the 10 percent penalty tax on any withdrawals that are taken after you reach age 59 ½, become disabled, or die.
Reminder. If you have several Roth IRAs, you must aggregate them and treat them as a single account to determine which layer(s) each withdrawal comes from and the resulting federal income tax consequences.
Tax Reporting for Non-Qualified Withdrawals
Just like when you take a qualified withdrawal, when you take a non-qualified Roth withdrawal, you should receive a Form 1099-R from the IRA trustee or custodian.17 Box 1 of your Form 1099-R should report the gross amount of the non-qualified withdrawal. Usually, box 2b will be checked to indicate that the trustee or custodian has not determined the taxable amount. But if the trustee or custodian knows the taxable amount, it could be reported in box 2a.
Box 7 of Form 1099-R should report distribution code T (exception applies) if the trustee or custodian knows the 10 percent penalty tax is not owed because you were age 59 1/2 or older, disabled, or dead when the non-qualified withdrawal was taken.
Box 7 of Form 1099-R should instead report distribution code J (early distribution) if the trustee or custodian thinks the 10 percent penalty tax is owed.
Don’t Overlook First-Time Home Purchase Exception for Under-Age-59-1/2 Account Owners
Assuming you’ve passed the five-year test, this exception allows federal-income-tax-free and penalty-free Roth IRA withdrawals to the extent you spend the money within 120 days on qualified acquisition costs for a principal residence.
This favorable exception is available even if you are under age 59 1/2. But there’s a $10,000 lifetime limit, and you must have passed the five-year test.
To the extent this exception applies, treat the applicable amount as a federal-income-tax-free qualified withdrawal.
Under this exception, the principal residence can be acquired by:18
you, as the Roth IRA account owner, or your spouse;
your child, grandchild, or grandparent; or
your spouse’s child, grandchild, or grandparent.
The buyer of the principal residence (and the buyer’s spouse, if the buyer is married) must not have owned a present interest in a principal residence within the two-year period that ends on the acquisition date.19 Qualified acquisition costs are defined as costs to acquire, construct, or reconstruct a principal residence—including closing costs.20
When you take a withdrawal that qualifies for this exception, you should receive a Form 1099-R from the Roth IRA trustee or custodian. Box 1 of the Form 1099-R should report the gross amount of the withdrawal.
Usually, box 2b will be checked to indicate that the trustee or custodian has not determined the taxable amount (if any).
Box 7 may report distribution code J (early distribution) if the trustee or custodian thinks the 10 percent penalty tax is owed because you were not age 59 1/2 or older or disabled or dead when the withdrawal was taken.
For a Roth IRA withdrawal that qualifies for this exception, enter the total withdrawal amount on line 4a of Form 1040.21 Enter the qualified home purchase expenses (subject to the lifetime
$10,000 limit) in Part III, line 20 of Form 8606 and follow the remaining instructions. Include the completed Form 8606 with your Form 1040.
Takeaways
Know this: There is no federal income tax hit on a qualified Roth withdrawal. You just have to make sure your withdrawal is actually qualified before pulling the trigger.
The tax rules for non-qualified Roth IRA withdrawals are complicated. That said, everything falls in place when you properly complete Part III of IRS Form 8606 and enter the proper amount (which might be zero) on line 4b of your Form 1040.
The other complicating factor for non-qualified withdrawals is the 10 percent early withdrawal penalty tax, which you must calculate on IRS Form 5329 when it applies.
If you plan to take one or more big non-qualified Roth IRA withdrawals during the year, you need to speak with your tax pro and have him or her advise you on both the front and back ends of your withdrawal.
1 IRC Section 408A(d)(2).
2 IRC Section 408A(d)(2)(B).
3 Form 1099-R (2021).
4 Form 1040, U.S. Individual Income Tax Return (2020).
5 IRC Section 72(t).
6 IRC Section 408A(d)(4); Reg. Sections 1.408A-6, Q&A-8; 1.408A-6, Q&A-9.
7 IRS Form 8606, Nondeductible IRAs (2020).
8 Form 1040, U.S. Individual Income Tax Return (2020).
9 IRC Sections 408A(d)(3)(F); 72(t).
10 Reg. Section 1.408A-6, Q&A-8.
11 IRS Form 8606, Nondeductible IRAs (2020).
12 IRS Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax- Favored Accounts (2020).
13 IRS Form 8606, Nondeductible IRAs (2020).
14 Ibid.
15 IRC Sections 408A(d)(2); 72(t); Reg. Section 1.408A-6, Q&A-5.
16 IRS Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax- Favored Accounts (2020).
17 Form 1099-R (2021).
18 IRC Sections 408A(d)(5); 72(t)(2)(F); 72(t)(8).
19 IRC Sections 408A(d)(5); 72(t)(2)(F); 72(t)(8).
20 IRC Sections 408A(d)(5); 72(t)(2)(F); 72(t)(8).
21 Form 1040, U.S. Individual Income Tax Return (2020).
Sourced with the help of The Bradford Tax Institute.
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