Nonqualified Roth IRA withdrawals can occur for two reasons:
- The account owner isn't yet 59½ and isn't dead or disabled, or
- The account owner fails the five-year test.
If you made several conversion contributions, you must use the first-in-first-out (FIFO) principle to determine which conversion contribution each withdrawal comes from for purposes of determining if you pass the five-year test for that withdrawal.
Nonqualified Roth withdrawals can potentially come from four different layers and different federal income tax rules apply to each layer. If you own several Roth IRAs, you must aggregate them and treat them as a single account for purposes of determining which layer(s) withdrawals come from and the resulting tax consequences.
Important: If your spouse owns one or more Roth IRAs in his or her own name, that doesn't affect how withdrawals from your Roth IRA(s) are taxed.
When you take nonqualified withdrawals, they're treated as coming from these four layers in the following order:
1. Annual Contributions
The first layer consists of the total annual contributions to all Roth IRAs set up in your name, less any withdrawals from this layer taken in previous years. Withdrawals from this layer are always federal-income-tax-free and penalty-free.
2. Taxable Portion of Conversion Contributions
After you've exhausted the first layer, any additional nonqualified withdrawals are treated as coming from the second layer, which consists of the taxable portion of any Roth conversion contributions you've made over the years. Conversion contributions can come from converting a traditional IRA into a Roth account or from contributing a retirement plan distribution — for example, from a 401(k) account — to a Roth IRA. The taxable portion of a conversion contribution is the amount of taxable income triggered by that contribution.
To determine how much you have in the second layer, review your tax returns and add up all the taxable conversion contributions to all Roth IRAs set up in your name. Then subtract any withdrawals taken from this layer in previous years.
Withdrawals from the second layer are always federal-income-tax-free. However, they aren't always penalty-tax-free. Unless you're eligible for a tax-law exception, you'll owe the 10% penalty tax on a nonqualified withdrawal taken from this layer if:
•You're under 59½, and
•The withdrawal is taken within five years of the conversion contribution to which it relates.
Ask your tax advisor about the tax-law exceptions. The five-year period starts on January 1 of the year during which you made the conversion contribution. If you made several conversion contributions, use the FIFO principle to determine which conversion contribution each withdrawal comes from.
3. Nontaxable Portion of Conversion Contributions
After you've exhausted the first two layers, any additional nonqualified withdrawals are treated as coming from the third layer, which consists of the nontaxable portion of any Roth conversion contributions. The nontaxable portion of a conversion contribution is the amount of nondeductible contributions included in that contribution. Withdrawals from this layer are always federal-income-tax-free and penalty-tax-free.
To determine how much you have in this layer, review your tax returns and add up all the nontaxable conversion contributions to all Roth IRAs set up in your name. Then subtract any withdrawals taken from this layer in previous years.
4. Account Earnings
After you've exhausted the first three layers, any additional nonqualified withdrawals come from the fourth layer, which consists of cumulative Roth IRA earnings. Nonqualified withdrawals from this layer are always 100% taxable. Plus, you'll be hit with a 10% early withdrawal penalty tax on any amount withdrawn from this layer, unless you're eligible for a tax-law exception.
Example: Tax Impact of Early Withdrawal
Here's an example of how these layers might come into play. In 2016, Tom converted a traditional IRA worth $90,000 into a Roth account. The entire $90,000 was a taxable conversion contribution (layer 2), because Tom hadn't made any nondeductible contributions to the traditional IRA. In 2018, Tom made a $5,000 annual contribution to the Roth IRA (layer 1). This is his only Roth IRA, and he made no more contributions after 2018.
In July 2020, at age 45, Tom decided to withdraw $105,000 to deal with coronavirus-related financial distress. At the time of the withdrawal, his Roth balance was $150,000. What are the tax implications of Tom's withdrawal?
•The first $5,000 of the withdrawal is treated as coming from layer 1 (the 2018 annual contribution). The amount is federal-income-tax-free and penalty-free.
•The next $90,000 is treated as coming from layer 2 (the 2016 taxable conversion contribution). The entire $90,000 comes out federal-income-tax-free. However, Tom will owe the 10% penalty tax on the entire $90,000, unless he's eligible for a tax-law exception. Why? First, he took out the $90,000 within five years of December 1, 2016 (the date he's deemed to have made the taxable conversion contribution that constitutes layer 2). Additionally, Tom wasn't yet 59½ as of the withdrawal date.
•The last $10,000 comes from layer 4 (account earnings). The entire $10,000 must be reported as gross income on Tom's 2020 federal income tax return. In addition, because Tom was under 59½ on the withdrawal date, the entire $10,000 will be hit with the 10% penalty tax, unless he's eligible for a tax-law exception.
Important: For the first $100,000 of his 2020 withdrawal, Tom might qualify for the special tax-favored treatment for coronavirus-related Roth IRA distributions. (See Taxes on Roth IRA Withdrawals Today article.) Your HK tax advisor can provide more details on this limited-time opportunity.