Is My Roth Distribution Taxable?
Investing in a Roth IRA gives you the opportunity to make withdrawals of your earnings without having to pay income tax on those earnings --- if you follow the rules. Earnings must meet specific criteria to be withdrawn on a tax-free basis. If earnings are withdrawn for any reason other than for specific exceptions, not only are withdrawals taxable, but they're also subject to a 10 percent penalty.
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The 5-Year Rule
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The key rule to Roth IRAs is that the account must be at least five years old for earnings in a Roth IRA to be withdrawn tax-free. Any distribution of earnings within the first five years of opening a Roth IRA is treated as a taxable event, even if it's for one of the specified exceptions in the IRS regulations. Deposits made into the account can be withdrawn at any time without tax consequences because they're "after-tax" dollars, meaning that you didn't receive a tax deduction for the contributions.
Age Restriction
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Distributions of earnings taken before you're 59 1/2 years old are normally treated as taxable distributions. These distributions are also subject to a 10 percent early withdrawal penalty. Certain exceptions permit early distributions of earnings without penalties or tax consequences as long as the Roth IRA is at least five years old.
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Tax-Free, Penalty-Free Exceptions
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The IRS regulations concerning Roth IRA distributions allow earnings distributions to be taken on a tax-free and penalty-free basis for three exceptions: the death or disability of the owner of the Roth IRA, or if the funds are being used to purchase or rebuild a first home. It should be noted that the IRS regulations may limit the amount of earnings that can be taken tax-free for a first-time home purchase.
Penalty-Free Exceptions
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The IRS tax code allows for four additional exceptions where earnings can be withdrawn from a Roth IRA. These withdrawals are taxable but aren't subject to the 10 percent early withdrawal penalty as long as the Roth IRA is at least five years old. The distributions must be used for higher education expenses; to pay for medical expenses that exceed 7 1/2 percent of your adjusted gross income; or to pay for health insurance premiums during unemployment.
The final exception involves taking "substantially equal periodic payments," also known as a Rule 72t distribution. Rule 72t distributions are used by people prior to age 59 1/2 who want to take penalty-free distributions from an IRA. According to the IRA Required Minimum Distribution website, the payments must continue for whichever time period is longer: five years or until the investor reaches age 59 1/2. Using Rule 72t can be quite complicated; working with a financial planner who can help you navigate the process is recommended.
Warning
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Before taking earnings from your Roth IRA, consider whether or not you have exhausted all other available resources. Preretirement distributions of Roth IRA earnings shouldn't be taken casually.
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References
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