Roth Distributions

We talked about Roth conversions earlier. Now let’s look at how you get the money out of a Roth. You first want to do some careful planning here. These funds are really special as they grow tax-free. Some people get confused and think they should spend interest before they spend principal. So they will spend the earnings on their IRA before they spend their non-IRA principal. However, this does not minimize their tax situation.

Your non-IRA money has already been taxed, so it might as well be used first. Your IRA money is either tax deferred or tax free, in the case of a Roth, so you want to leave it untouched. In other words, from a tax standpoint, it’s better to spend down your non-IRA principal before touching any of your IRA money. Since there is no difference between principal and interest (it’s all green), you should forget the distinction because it’s all your money and does not matter how you label it. The whole idea of principal and interest is something we made up!

So you see why allowing your IRA money to grow is likely preferable. (Many financial planners have software that can answer the question of which “buckets” of money should be used first for potential lifetime tax minimization).

Additionally, there may be restrictions removing money from a Roth conversion. Here’s how they work.

First, if you are younger than 59½ and you remove money from a Roth within 5 years of conversion, you will owe a 10% early withdrawal penalty. (Note that the 5-year measurement for Roth conversion distributions starts from the first day of the tax year in which the conversion is made.)

Next, when you withdraw funds, IRA classifies each dollar as follows in this order:

1. Roth contributions (assuming you did a conversion and it’s the first time you have had a Roth, this will be zero).
2. Roth conversion money, in chronological order if more than one, first the taxable amounts and then any non-taxable amounts rolled over of each conversion.
3. Earnings on Roth contributions or conversions.

Table 3.3: Roth distributions if under age 59½

* The allowed exceptions are: a first-time home purchase (lifetime maximum is $10,000); post-secondary education expenses; substantially equal periodic payments taken under IRS guidelines; medical expenses exceeding 7.5% of your adjusted gross income; an IRS levy; health insurance premiums (after you have received at least 12 consecutive weeks of unemployment compensation); disability; death.

Table 3.4: Roth distributions if age 59½

Let’s assume you have no Roth contributions and that you are age 62. You only have converted amounts in your Roth. You are free to make distributions at any time and you will pay tax on any earnings if the account is not five years old, as determined by the earliest conversion. After five years, all distributions are taxfree. So as a practical matter, prior to five years after conversion, very little of the money will be earnings—it will be mostly the converted balance. And since the converted balance is deemed by IRS to be withdrawn before earnings, you can withdraw most of your Roth balance without tax because the earnings amounts are considered withdrawn last.

Regarding mandatory distributions—there are no mandatory distributions for the owner of a Roth IRA or the spouse that inherits. But a non-spouse beneficiary must make mandatory distributions over his or her life expectancy. The penalty is 50% of the amount not taken.

(1) IRS Publication 590 contains the Roth distribution rules summarized here