How to Determine Whether Your Roth IRA Distributions Will Be Taxed

While most Roth IRA distributions are tax-free, there are two instances where they can be taxable. This article will explain both of those situations.

Instructions

Difficulty: Moderately Easy

1. Roth IRAs are widely known for their ability to provide tax-free income to investors. But there are two situations where Roth income can become taxable. Roth IRA holders need to familiarize themselves with each possible scenario so that they can be avoided whenever possible.
2. The first exception to the tax-free rule is for early distributions. Whenever money is taken out of a Roth IRA before age 59 1/2, the entire balance withdrawn that is not considered to be a return of principal is subject to both tax and penalty. Account holders that must take early distributions from their Roth accounts would be wise to limit their withdrawals to the amount of their aggregated contributions or less if possible.
3. The other instance where Roth income can be taxed is when earnings from the Roth IRA are distributed from a Roth account that is less than five years old. For example, say you open a Roth IRA and contribute $4000 to the account this year. Four years from now you reach age 59 1/2 and liquidate the Roth account. The $4000 has grown to $5500 in that time, so there is $1500 of earnings in the account. The $1500 will be taxed as ordinary income because it has been growing for less than five years, even though the account holder is age 59 1/2.

Tips & Warnings

• As long as neither of these situations applies, your Roth IRA account will never be taxed. For simplicity's sake, it might be easier to wait five years from the time of your last contribution before taking any distribution so that there is no chance of partial taxation.