In Part A, we discussed the tax free Roth IRA withdrawals, and pointed out there are two situations even Roth IRA withdrawals are not tax-free. Now, the first situation.
a. When You Are Under 59½
Any Roth withdrawal taken before 59½ is a nonqualified withdrawal. As such, it’s potentially (but not necessarily) subject to federal income tax and a 10% penalty tax. However, there are three layers of the withdrawals and the consequences are different:
1. Withdrawals from Principal Contributions
Nonqualified withdrawals are treated on the first-in first-out basis, meaning they come out of your Roth IRA contributions over all the years first. These withdrawals are tax free.
2. Withdrawals from Roth Conversions
Next, nonqualified withdrawals will come out of your Roth conversion contributions, if any. These are contributions from converting a traditional IRA into a Roth or from contributing a retirement plan payout (like from a 401(k) plan) to a Roth.
To figure out how much is in this layer, add up all conversion contributions to all Roth IRAs set up in your name (ignore any accounts in your spouse’s name). Withdrawals from this layer are federal-income-tax-free, but you could still get hit with a 10% penalty tax.
To prove you don’t owe any income tax, fill out Part III of Form 8606. The 10% penalty tax applies unless:
1) the conversion contribution was more than five years before the withdrawal date (the five-year period starts on January 1 of the year when the conversion contribution occurred), or
2) you’re eligible for an exception. (For a list of the exceptions, see How to make penalty-free IRA withdrawals.) If you owe the penalty tax, fill out IRS Form 5329 (Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Plans) and enter the penalty on line 58 of Form 1040.
3. Withdrawals from Roth IRA Earnings
Finally, any further nonqualified withdrawals from Roth accounts set up in your name (after you’ve sucked out all your contributions) are deemed to come from the layer consisting of Roth IRA earnings. Nonqualified withdrawals from this layer are 100% taxable.
You need to fill out Part III of Form 8606 to calculate the taxable amount from this layer, and enter that figure on Line 15b of Form 1040. In addition, the 10% penalty tax applies to nonqualified withdrawals taken from this layer unless you’re eligible for an exception. If you owe the penalty tax, fill out Form 5329 and enter the penalty on line 58 of Form 1040.
In Part C, we will discuss the second situations - when you don't meet the account 5-year test.
a. When You Are Under 59½
Any Roth withdrawal taken before 59½ is a nonqualified withdrawal. As such, it’s potentially (but not necessarily) subject to federal income tax and a 10% penalty tax. However, there are three layers of the withdrawals and the consequences are different:
1. Withdrawals from Principal Contributions
Nonqualified withdrawals are treated on the first-in first-out basis, meaning they come out of your Roth IRA contributions over all the years first. These withdrawals are tax free.
2. Withdrawals from Roth Conversions
Next, nonqualified withdrawals will come out of your Roth conversion contributions, if any. These are contributions from converting a traditional IRA into a Roth or from contributing a retirement plan payout (like from a 401(k) plan) to a Roth.
To figure out how much is in this layer, add up all conversion contributions to all Roth IRAs set up in your name (ignore any accounts in your spouse’s name). Withdrawals from this layer are federal-income-tax-free, but you could still get hit with a 10% penalty tax.
To prove you don’t owe any income tax, fill out Part III of Form 8606. The 10% penalty tax applies unless:
1) the conversion contribution was more than five years before the withdrawal date (the five-year period starts on January 1 of the year when the conversion contribution occurred), or
2) you’re eligible for an exception. (For a list of the exceptions, see How to make penalty-free IRA withdrawals.) If you owe the penalty tax, fill out IRS Form 5329 (Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Plans) and enter the penalty on line 58 of Form 1040.
3. Withdrawals from Roth IRA Earnings
Finally, any further nonqualified withdrawals from Roth accounts set up in your name (after you’ve sucked out all your contributions) are deemed to come from the layer consisting of Roth IRA earnings. Nonqualified withdrawals from this layer are 100% taxable.
You need to fill out Part III of Form 8606 to calculate the taxable amount from this layer, and enter that figure on Line 15b of Form 1040. In addition, the 10% penalty tax applies to nonqualified withdrawals taken from this layer unless you’re eligible for an exception. If you owe the penalty tax, fill out Form 5329 and enter the penalty on line 58 of Form 1040.
In Part C, we will discuss the second situations - when you don't meet the account 5-year test.
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