Financial Planning and Analysis

How Roth IRA Distribution Ordering Rules Work

Not all money in your Roth IRA is treated equally upon withdrawal. Learn the specific sequence funds are paid out to plan for tax-efficient distributions.

The Internal Revenue Service (IRS) has established regulations that dictate the sequence for withdrawing funds from a Roth IRA. These ordering rules are fundamental for understanding the tax implications of any money you take out. This is particularly important when dealing with “non-qualified distributions,” which are withdrawals that do not meet certain IRS criteria. The rules create a clear, non-negotiable hierarchy for how money leaves the account, ensuring that both the account owner and the IRS can accurately calculate any resulting tax liability.

Understanding Qualified vs. Non-Qualified Distributions

The tax treatment of a Roth IRA withdrawal hinges on whether it is classified as a “qualified” or “non-qualified” distribution. A qualified distribution is always completely free from federal income tax and penalties. To achieve this favorable tax status, a withdrawal must satisfy two primary conditions.

First, the Roth IRA must meet its five-year holding period. This clock starts on January 1 of the tax year for which the very first contribution was made to any of your Roth IRAs. For instance, if you funded a Roth IRA for the 2023 tax year, the period began on January 1, 2023. This rule applies to you as the owner, and once met, it is met for all Roth IRAs you own.

Second, the withdrawal must be made for a specific, IRS-approved reason. The most common qualifying event is reaching age 59½. Other qualifying reasons include the account owner’s death, total and permanent disability, or a withdrawal for a first-time home purchase. The first-time homebuyer exception has a lifetime limit of $10,000 per person.

Any withdrawal that fails to meet both conditions is deemed a non-qualified distribution. The ordering rules then determine if any portion is subject to income tax and potentially a 10% early withdrawal penalty.

The Three-Tier Withdrawal Order

For any non-qualified distribution, the IRS mandates a three-tier order of withdrawal to determine tax consequences. You cannot choose which pool of money to tap, as funds come out in a specific sequence that is favorable to the account owner.

Tier 1: Regular Contributions

The first money to be withdrawn from a Roth IRA is always your direct, regular contributions. This portion of any distribution is completely tax-free and penalty-free, regardless of your age or how long the account has been open. Since you made these contributions with after-tax dollars, the IRS allows you to take back your principal at any time without consequence. For example, if you contribute $6,000 to your Roth IRA, you can withdraw that same $6,000 the next day without owing any tax or penalty.

Tier 2: Converted Amounts

After your regular contributions are depleted, withdrawals are taken from funds that were converted from traditional IRAs. If you have made multiple conversions over the years, these are withdrawn on a first-in, first-out (FIFO) basis, meaning the earliest conversion is withdrawn first. Within each conversion, the portion that was taxable at the time of conversion is considered withdrawn first, followed by the non-taxable portion of the conversion.

A separate five-year holding period applies to each conversion to avoid a 10% early withdrawal penalty. This clock starts on January 1 of the year the conversion was made. If you are under age 59½ and withdraw from a conversion within its five-year period, the penalty applies only to the taxable portion of that conversion.

For example, assume you converted a traditional IRA with $20,000 in pre-tax funds three years ago. If you withdraw that $20,000 today and are under 59½, the withdrawal is income-tax-free but is subject to a $2,000 penalty because it was withdrawn within the five-year period.

Tier 3: Earnings

The last money to come out of a Roth IRA is the investment earnings. This includes interest, dividends, and capital gains that have accumulated in the account. If a distribution is non-qualified, this is the only portion that is subject to ordinary income tax. If you are under age 59½ when you withdraw earnings, those earnings are also subject to the 10% early withdrawal penalty.

Imagine you have a Roth IRA with $30,000 in contributions, $10,000 from a conversion of all pre-tax money made three years ago, and $5,000 in earnings. If you take a non-qualified distribution of $42,000, the first $30,000 is a tax-free return of your contributions. The next $10,000 is the converted amount, which is income-tax-free but subject to a $1,000 penalty. The final $2,000 is from earnings, subject to both ordinary income tax and a $200 penalty.

Special Considerations and Reporting

Navigating Roth IRA distributions requires understanding a few additional rules. These rules address the different five-year clocks, how the IRS views multiple accounts, and the correct reporting procedures.

Clarifying the Two 5-Year Rules

It is important to distinguish between the two separate five-year rules for Roth IRAs. The first is the account-level holding period for determining if a distribution is “qualified.” This clock starts with your first-ever contribution and helps make the earnings portion of a qualified distribution tax-free.

The second five-year rule applies separately to each conversion from a traditional IRA. This rule determines if the taxable portion of a converted amount is subject to the 10% early withdrawal penalty. Each conversion has its own five-year waiting period to avoid this penalty.

Multiple Roth IRAs

For calculating the taxability of distributions, the IRS aggregation rule treats all of your Roth IRAs as a single account. You cannot isolate contributions in one account to withdraw them separately. A distribution from any Roth IRA is considered a withdrawal from the combined total of all contributions, conversions, and earnings across all your accounts.

Reporting Distributions to the IRS

When you take a distribution, your custodian reports the gross amount to you and the IRS on Form 1099-R. It is your responsibility to calculate the taxable portion, if any, by applying the ordering rules on IRS Form 8606, Nondeductible IRAs. Part III of this form is used to determine how much of your distribution is tax-free principal versus taxable earnings. The result determines the taxable amount to report on your Form 1040 tax return.

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