If you're experiencing financial distress during the COVID-19 crisis, you might be thinking about tapping into your Roth IRA to improve your cash situation. But before withdrawing money from a Roth account, it's important to understand the federal income tax consequences, especially if you're under 59½.
You may think that all withdrawals from Roth IRAs are federal-income-tax-free. Unfortunately, that's not true. Some withdrawals are taxable. On top of that, some early withdrawals (taken before you turn 59½) can potentially get hit with a 10% penalty tax.
Only qualified Roth IRA withdrawals are federal-income-tax-free. To be eligible for tax-free treatment, you must:
•Be at least 59½ (or dead or disabled), and
•Have had at least one Roth IRA open for over five years.
The five-year period for determining if you pass the five-year test begins on January 1 of the first tax year for which you make a Roth contribution. It can be a regular annual contribution or a conversion contribution.
If both conditions are satisfied, all withdrawals from any Roth account set up in your name will be qualified withdrawals. As such, they are federal-income-tax-free and penalty-tax-free.
Complex Rules for Nonqualified Withdrawals
Any nonqualified withdrawal from a Roth IRA is potentially subject to federal income tax. In addition, early nonqualified withdrawals are potentially subject to a 10% penalty tax on top of the income tax hit. You may also owe state income tax.
Nonqualified withdrawals most commonly occur in two scenarios:
1. You take a withdrawal before age 59½, or
2. You take a withdrawal before passing the five-year test.
Nonqualified withdrawals are handled under a four-layer system. (See "4 Layers of Nonqualified Withdrawals" below.) If you own several Roth IRAs, you must aggregate them and treat them as a single account to determine which layer(s) each nonqualified withdrawal comes from and the resulting federal income tax consequences.
Exceptions for Certain Early Withdrawals
Any Roth withdrawal taken before you turn 59½ is, by definition, a nonqualified withdrawal, unless you're:
•Eligible for the special first-time homebuyer rule.
To be eligible for the first-time homebuyer rule, you must first pass the five-year test. In addition, you must spend the amount you've withdrawn within 120 days to pay qualified principal residence acquisition costs. However, there's a $10,000 lifetime limit on this special rule. To the extent the special rule applies to your Roth withdrawal, the qualified amount is free from federal income tax and free from the 10% early withdrawal penalty tax.
The principal residence can be purchased by:
•The Roth account owner,
•The Roth account owner's spouse, child, grandchild or grandparent, or
•A child, grandchild or grandparent of the Roth account owner's spouse.
The homebuyer (and the buyer's spouse if the buyer is married) must not have owned a principal residence within the two-year period that ends on the acquisition date. Qualified acquisition costs are defined as those spent to acquire, construct or reconstruct a principal residence, including closing costs.
Any Roth IRA withdrawal taken before age 59½ that doesn't fall within one of the preceding exceptions is a nonqualified withdrawal and is taxed under the four-layer system. (See "4 Layers of Nonqualified Roth IRA Withdrawals" below.)
Coronavirus-Related Roth IRA Distributions
Thanks to the Coronavirus Aid, Relief and Economic Security (CARES) Act, you may qualify to take a tax-favored coronavirus-related distribution from a Roth IRA in 2020 only. To be eligible, you must be considered to have been adversely affected by the pandemic.
An eligible individual can take one or more coronavirus-related distributions from one or more Roth IRAs set up in his or her name, totaling up to $100,000. Subject to the $100,000 limit, such distributions are completely exempt from the 10% early withdrawal penalty tax.
Under complicated rules, you can recontribute a coronavirus-related distribution back into a Roth IRA within three years of when the distribution was received — and eventually avoid any federal income tax hit.
As a general rule, you're well-advised to leave Roth IRA balances untouched, so you can keep earning tax-free income and gains. Sometimes, however, that's not possible. Consult your HK tax advisor to discuss the complex tax rules before making any significant Roth IRA withdrawal.