Are Roth IRA Earnings Taxable?
As with all types of individual retirement accounts, Roth IRA earnings are not taxed as long as they remain in the account. However, Roth IRAs are unique in that qualified distributions are tax-free as well. Usually, you must be age 59 1/2 to take a qualified, tax-free distribution from your Roth IRA, but there are exceptions.
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Benefits
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Unlike a traditional IRA, you pay income tax on your annual Roth IRA contributions. But Roth IRAs provide a long-term benefit -- you do not owe taxes on qualified distributions. Any earnings your Roth IRA assets make are potentially tax-free. Over decades of investing, Roth IRAs can help you accumulate a sizable nest egg, as you can reinvest 100 percent of your investment earnings and not pay taxes on them.
The Five-Year Rule
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To take any kind of qualified distribution from your Roth IRA, your account must be open for at least five years. Internal Revenue Service rules stipulate that the five-year period begins on Jan. 1 of the year in which you apply your first Roth IRA contribution. Note that this may be different from the calendar year in which you make your first Roth IRA contribution. If, for instance, you made a Roth IRA contribution before the April 15 filing deadline in 2010, you had the option of applying it to 2009; in which case, the five-year period would have started on Jan. 1, 2009.
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Types of Qualified Distributions
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As long as your account has been open at least five years, you may be able to take a qualified distribution from your Roth IRA if you meet one of several criteria. You can take unlimited distributions from your account beginning the year you turn age 59 1/2. You may also qualify for unlimited, tax-free access to your Roth IRA if you become disabled. You can withdraw up to $10,000, as of 2010, to pay for your first home. If you die before age 59 1/2, your Roth IRA beneficiaries may take penalty-free withdrawals from your account.
Significance
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If you take a distribution from your Roth IRA before age 59 1/2 and do not qualify for one of the exceptions, you may owe income taxes and a 10 percent penalty on your Roth IRA's earnings. However, you may always withdraw the entire amount of your Roth IRA contributions without tax or penalty.
Ordering Rules
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The IRS has established what it calls "ordering rules" that determine which types of Roth IRA funds you may withdraw when taking an early distribution. First, you may withdraw your contributions without paying tax or penalty. Then, you may dip into your taxable rollovers -- amounts on which you paid income taxes. Unless you qualify for an exception, you may owe a 10 percent penalty for withdrawing these amounts. After that, you must distribute your nontaxable rollovers. You do not owe tax or penalties on these amounts. If you deplete these portions of your Roth IRA, then you access your assets' earnings. If you do not qualify for a penalty exception, you may owe income taxes and the 10 percent early-withdrawal penalty on these amounts.
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