Several relevant provisions of the Tax Cuts and Job Act (TCJA) are on track to expire in 2025. Taxpayers today are benefitting from the TCJA’s reduction of individual income rates, increased child tax credit, and the increased standard deduction. In other words, ultimately, taxes for most of us will increase after these benefits expire in 2025. One strategy that is getting a lot of attention right now because tax rates are temporarily lower than they will be in the future is increasing Roth IRA balances. The next logical question after you convert to a Roth or contribute to a Roth IRA is, when should you take your Roth IRA distributions?
Investors flock to Roth IRAs when they hear tax free distributions. It is not a completely tax-free situation, though; you pay the taxes upfront when your funds are invested in the Roth IRA. There are two main strategies to fund a Roth IRA, either through contributions or through conversions.
In 2023, you may contribute up to $6,500 ($7,500 if 50 or older) to a Roth IRA from a non-retirement account such as a brokerage account or a checking account. Not everyone is eligible to make Roth IRA contributions; your income level dictates your eligibility. In 2023, if married filing jointly and you make under $218,000, you are eligible; above that level, the amount you can contribute is phased out to zero. A Roth conversion occurs when you move funds that are already in a retirement account to a Roth IRA. You will pay tax on the conversion, and there is no limit on the amount you may convert.
Once you have funded your Roth IRA, there are several rules to follow when you are taking a distribution to make sure you are reaping the benefits.
Generally, you want to be at least 59 1/2 before you tap into any retirement account. Roth IRAs have an additional requirement to consider, known as the five-year rule. You must have your Roth IRA funded for at least five years, even if you are already 59 1/2 to take funds out tax-free without any penalties, known as a qualified distribution. Qualified distributions are those that check all the boxes for the Roth IRA distribution rules and are tax-free. Non-qualified distributions do not check the boxes, and the benefits of a Roth IRA will be curtailed either through taxes or penalties.
Non-qualified distributions are red flags!
If you are considering taking money out of a Roth IRA before you are 59 ½, evaluate how long the funds have been in the Roth IRA. Five years is a critical mile marker for Roth IRAs. If your money has been in the account for less than five years, you are in ‘unqualified distribution’ territory.
In the scenario that you are taking money out of a Roth IRA when you are younger than 59 ½ and have had the account for less than five years, you will be taking an unqualified distribution and be facing penalties. You will be facing a 10% penalty on the distribution on any earnings. You will also be paying tax (at your ordinary-income rate) on the earnings, negating all the benefits of a Roth IRA.
Luckily, there are multiple exceptions to avoid the 10% penalty. You will still have to pay the taxes on the earnings; there is no avoiding the five-year rule. If you are taking money out for any of the following reasons, you should qualify for one of the exceptions to the 10% penalty as listed by the IRS:
- You are totally and permanently disabled.
- You are the beneficiary of a deceased IRA owner.
- You use the distribution to buy, build, or rebuild a first home.
- The distributions are part of a series of substantially equal payments.
- You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income (defined earlier) for the year.
- You are paying medical insurance premiums during a period of unemployment.
- The distributions aren’t more than your qualified higher education expenses.
- The distribution is due to an IRS levy of the qualified plan.
- The distribution is a qualified reservist distribution.
Order of operations
We generally look to Roth IRAs to be used last when you think about all of your accounts. In other words, they are intended to grow for as long as possible and to be used in retirement, after your other accounts have been depleted. Check out our blog ‘Reduce retirement risk with an effective retirement distribution strategy before it’s too late’ to learn how Roth IRAs play a piece in an efficient distribution plan. In reality, Roth IRAs are often tapped into too early. The IRS has an order of operations to evaluate the consequences of early distributions.
When you take money out of a Roth IRA early, the IRS views the distribution as regular contributions coming out first (not taxable). Then conversion and rollover contributions are the next piece (could be partially taxable)—lastly, your earnings on contributions (taxable).
Understanding the order of operations is crucial to estimate how much taxes will eat into your early distribution. If you don’t meet one of the exception criteria, stick to only taking out an amount up to how much you have contributed; otherwise, the withdrawal will be facing the penalty plus a piece being taxed at your ordinary-income rate.
Getting more specific, you must keep track of when the five year time period starts and when you reach it to ensure you are following all of the Roth IRA distribution rules.
Keeping track of the time period is straightforward with contributions. The five year period starts with your first contribution tax year in a Roth IRA. Conversions and rollovers are a little trickier. Each conversion and rollover have their own time periods; you must keep track of them separately.
For example, if you made your first Roth IRA contribution for the tax year 2019 in March 2020, the five year period began January 1, 2019. If you do a conversion in April 2020, the five year period for that piece started January 1, 2020. Remember, you can make prior-year contributions, but you can’t make prior-year conversions.
The last significant milestone is when you reach 59 ½, then the world of Roth distributions is your oyster. Distributions are ‘qualified’ (as long as you are also meeting the five-year rule) and do not count towards your gross income. As a qualified distribution, the funds are tax-free! Note, the five-year time frame doesn’t go away once you hit the 59 ½ milestone.
There are no milestones after 59 ½ because you do not have ‘required minimum distributions’ beginning at age 72 as you do with Traditional IRAs. You can be more flexible with your Roth IRA distribution plan since you don’t have any requirements to satisfy.
The flexibility and the tax-free distributions capture the significant advantage Roth IRAs have over other account types. In retirement, Medicare costs for high-income earners are often higher than they expect because of surcharges. The surcharges increase as your income increases. However, Roth IRA distributions don’t count towards your income, thus not increasing your Medicare surcharge.
We can be strategic with your retirement income streams to plan to help you stay under income thresholds so that you don’t end up paying extra for Medicare. Retirement healthcare costs constitute a significant part of your retirement expenses; the more we can limit penalties or surcharges, the better.
Roth IRAs should be a piece of a broader financial picture, complimented by employer retirement plans, taxable accounts, and an emergency fund. Diversifying your account types allows you to be more flexible and strategic throughout your financial journey.