Do You Pay Taxes on a Roth IRA Withdrawal?
The tax outcome of a Roth IRA withdrawal depends on a specific sequence and key factors like your age and how long your account has been open.
Withdrawals from a Roth Individual Retirement Arrangement (IRA) can be entirely tax-free, but this favorable treatment is not automatic. The core appeal of a Roth IRA is that contributions are made with after-tax dollars, which allows for investment growth and eventual distributions in retirement to be free from federal income tax. However, whether you pay taxes and penalties depends on specific Internal Revenue Service (IRS) rules. The timing of your withdrawal and the reason for it are the primary factors that determine its tax status.
Defining a Qualified Withdrawal
For a Roth IRA distribution to be completely free of taxes and penalties, it must be a “qualified distribution,” a status achieved by satisfying two distinct conditions. If either one of these requirements is not met, the withdrawal may be subject to taxes and penalties on the earnings portion of the account.
The first condition is the five-year rule. You must have held a Roth IRA for at least five tax years before you can withdraw any earnings tax-free. This five-year clock starts on January 1 of the tax year for which you made your very first contribution to any Roth IRA. For instance, if you opened and contributed to your first Roth IRA for the 2023 tax year, even if you made the contribution on April 15, 2024, the clock began on January 1, 2023. Once this five-year period is satisfied for one Roth IRA, it is satisfied for all Roth IRAs you own.
You must also have a qualifying reason for the withdrawal. The most common reason is reaching age 59½. Other circumstances that qualify include the funds being used by a beneficiary after your death, a withdrawal made because you are totally and permanently disabled, or using the funds for a qualified first-time home purchase. The first-time homebuyer provision is limited to a lifetime maximum of $10,000.
Understanding Non-Qualified Withdrawals and Ordering Rules
A withdrawal that does not meet both conditions for a qualified distribution is considered “non-qualified.” This does not automatically mean the entire amount is taxed. The IRS has established a specific order in which funds are considered to be withdrawn from a Roth IRA, which determines the tax consequences.
The first funds to be distributed are your direct contributions. Since you made these contributions with money you had already paid taxes on, they can be withdrawn at any time, for any reason, completely free of both income tax and penalties.
After you have withdrawn all direct contributions, the next funds distributed are amounts converted from other retirement accounts, such as a Traditional IRA. These converted amounts are also generally withdrawn tax-free, as you would have paid income tax on them at the time of the conversion. A separate five-year rule applies to each conversion to avoid a 10% penalty on the withdrawal of these funds, but they are not subject to income tax again.
Only after all contributions and converted balances have been fully withdrawn do you begin to take out the investment earnings. This is the only portion of a non-qualified distribution that is subject to ordinary income tax and, typically, a 10% early withdrawal penalty. For example, if your Roth IRA contains $30,000 in contributions and $8,000 in earnings, a non-qualified withdrawal of $35,000 would consist of your $30,000 in contributions (tax- and penalty-free) and $5,000 of earnings, with only the $5,000 being taxable and subject to the penalty.
Exceptions to the 10% Early Withdrawal Penalty
Even if you take a non-qualified distribution and must pay income tax on the earnings portion, you may be able to avoid the additional 10% early withdrawal penalty. The IRS provides several exceptions to this penalty, which do not eliminate the income tax due on the earnings but do waive the penalty.
Common exceptions to the 10% penalty include withdrawals for:
- Qualified higher education expenses for yourself, your spouse, children, or grandchildren.
- Unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI).
- Health insurance premiums while you are unemployed.
- A total and permanent disability.
- Use by a beneficiary from an inherited IRA after the owner’s death.
- A series of substantially equal periodic payments (SEPP).
- An IRS levy.
- A qualified birth or adoption (up to $5,000).
Tax Reporting for Roth IRA Distributions
Properly reporting your Roth IRA distribution to the IRS is a necessary step, regardless of whether the withdrawal is taxable. The process involves forms you receive from your financial institution and forms you file with your tax return.
Early in the year following your withdrawal, your IRA custodian will send you Form 1099-R. This form reports the total amount of your distribution. Pay close attention to Box 7, which contains a distribution code. For example, a code ‘Q’ indicates a qualified distribution, while a code ‘J’ signifies an early distribution from a Roth IRA, which may or may not be taxable.
When you file your taxes, you may need to complete Part III of Form 8606 if you take a non-qualified distribution. On this form, you will apply the ordering rules, showing the IRS your basis in contributions and calculating the taxable portion of your withdrawal, if any. The information from Form 1099-R is used to begin this calculation, and the result from Form 8606 determines the amount included in your taxable income on Form 1040.