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Roth IRA Rules

by Craig Moser on February 26, 2019

Roth IRAs offer a unique trade-off.  You pay taxes now on money contributed or converted to a Roth IRA.  In exchange, your future earnings and withdrawals are tax-free.  However, there are rules that must be followed.  Because we don’t want you to miss out on the benefits, here are six Roth IRA rules you should know.

1.  Aggregate your Roth IRAs.

For tax considerations, all of your Roth IRAs are one Roth account. Because the math is the same, and there is no tax benefit in keeping each conversion in separate Roth IRA accounts. (Roth IRA aggregation rule).

2.  Follow the ordering rules.

Funds are distributed from your Roth IRAs in a certain order:

  1. Contribution amounts
  2. Converted Amounts (in a first in, first out approach)
  3. Earnings

3.  Your contributions are always available tax and penalty free.

Not only do your contributions come out first, but they should always be available tax and penalty free.  Remember, you already paid taxes when you funded or converted into your Roth IRA.  As a result, you can easily access contributions without tax concerns.

4.  Funds that you have converted to a Roth IRA may be subject to a penalty.

Withdrawals of converted funds are always tax-free. This makes sense because you paid taxes when you converted them. However, amounts that were taxable at conversion may be subject to a 10% early distribution penalty.  This applies if you are under the age of 59½ at the time you take a distribution, and if the conversion was less than five years ago. This five-year clock begins separately for each conversion. If you are over age 59 ½ when you take converted dollars from your Roth IRA, you should have no concerns about this five-year “look back”.

5.  Qualified distributions of earnings are tax-free.

These earnings are not subject to taxation if the distribution is a qualified distribution.  Distributions are qualified when:

  • the Roth IRA account has been owned for five years, or
  • you are at least 59 1/2 years old, or
  • you become deceased, or
  • you become disabled, or
  • funds are used to purchase your first home

6.  Watch the five-year look back for qualified distributions of earnings.

The five-year period for qualified distributions of earnings can be confusing. This process is different than the five-year period for penalty-free distributions of converted funds explained above. The five-year period doesn’t re-start for each Roth IRA contribution or conversion.  Roth IRA rules state, to be tax free, you must withdraw earnings 5 tax years after your first contribution to any Roth IRA. For example, assume you contribute $1 to your Roth IRA in tax year 2014.  In 2016 you convert a one-million-dollar traditional IRA to the Roth IRA.  As of January 1, 2019, all money in your Roth IRA has been held for five years.  In other words, your first contribution was in 2014,  so your Roth IRA 5-year hold period began in tax year 2014. Clear as mud, I know.   Primarily, having a better understanding of the Roth IRA rules can help you maximize your tax benefits.

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