If you own a Roth IRA>, you may be under the impression that you'll never owe any federal income tax on withdrawals. Not true. Even worse, some withdrawals can be socked with a 10% penalty on top of the income tax bill. Here's what you need to know.
The Simplest Case
If you're 59 or older and have had at least one Roth IRA open for more than five years, withdrawals from any of your Roth IRAs are called qualified withdrawals. As such, they are free of any federal income tax or penalty. The five-year period for qualified withdrawals starts on January 1 of the first tax year for which you make a Roth contribution.
For example, assume you established your first Roth IRA on April 15, 2006. If the contribution was for the 2005 tax year, your five-year period would start on Jan. 1, 2005. Anytime after Jan. 1, 2010, you can take tax-free qualified withdrawals from any and all Roth IRAs that you own by then--as long as you're 59 or older. If, for instance, you opened a second Roth account in 2008 by converting a traditional IRA, you can take tax-free qualified withdrawals from that account too after Jan. 1, 2010--as long as you're at least 59 .
It gets complicated if
You're under 59 : Any Roth withdrawal taken before 59 is a nonqualified withdrawal. As such, it may be subject to federal income tax and a 10% penalty tax. Here's how nonqualified withdrawals are treated in this scenario.
As far as the IRS is concerned, nonqualified withdrawals come first from your annual Roth contributions, as opposed to any investment gains. Withdrawals from this layer are always tax-free and penalty-free. To figure out how much is in this layer, add up the annual contributions to all Roth IRAs set up in your name (ignore any accounts in your spouse's name). (To prove you don't owe any income tax or penalty, you'll have to fill out Part III of IRS Form 8606 (Nondeductible IRAs) and file it with your Form 1040.)
Next, nonqualified withdrawals are deemed to come from Roth conversion contributions, if any. To figure out how much is in this layer, add up all conversion contributions from converting a traditional IRA or a retirement plan payout 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. The 10% penalty applies unless: (1) it has been more than five years since the conversion contribution (the five-year period starts on Jan. 1 of the year when the conversion contribution occurred) or (2) you're eligible for an exception. To prove you don't owe any income tax, fill out Part III of Form 8606, and if you owe the 10% penalty, 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.
Finally, any further nonqualified withdrawals from Roth accounts set up in your name (after you've tapped all your contributions) are deemed to come from the layer consisting of Roth IRA earnings (investment gains). Nonqualified withdrawals from this layer are 100% taxable. 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 applies, 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.
If you fail the five-year test: Any Roth withdrawal taken before passing the five-year mark is also a nonqualified withdrawal. As such, it may besubject to income tax and a 10% penalty tax. In this scenario, nonqualified withdrawals are generally handled in the same order as above first from annual contributions, then from conversion contributions, and lastly from investment gains. Most importantly, nonqualified withdrawals from investment gains are subject to income tax, and, if you're under 59-1/2, the 10% penalty (unless you're eligible for an exception). Fill out Part III of Form 8606 to calculate the taxable amount from investment gains, and enter that figure on Line 15b of Form 1040. If you owe the penalty tax, fill out Form 5329 and enter the penalty on line 58 of Form 1040.
If you qualify for the home purchase exception: If you've passed the five-year test but you're under 59 , a special exception allows tax-free and penalty-free Roth withdrawals in order to buy a principal residence. However, there's a lifetime $10,000 limit on this deal, and you must use the money within 120 days of the withdrawal. The homebuyer can be you or certain relatives (including kids and grandkids). However, the buyer must not have owned a principal residence within the two-year period ending on the purchase date.
The Last Word
While the tax rules for nonqualified Roth withdrawals are complicated, everything falls in place when you complete Part III of Form 8606. One more thing: shortly after the end of any year you take withdrawals, you should receive a Form 1099-R from the Roth trustee or custodian. It shows the total amount of withdrawals for the preceding year, and the IRS gets a copy. So if you took any nonqualified withdrawals, the Feds will expect to see a Form 8606 included with your return.