Though Roth IRAs have been available for 25 years, they have historically comprised a very small portion of overall IRA assets held by individuals.
That is, until recent years.
Roth IRA assets rose to $1.3 trillion in 2021 from $660 billion in 2015, according to the Investment Company Institute. In total, 27 million households owned a Roth IRA in 2021.
Over the past decade, the use of Roth accounts has grown for several reasons.
First, more investors have access to Roth accounts through designated Roth accounts in employer-sponsored retirement plans. Also, since 2010, Roth conversions have been available to all taxpayers, regardless of income level. With the threat of higher tax rates in the future, taxpayers are interested in the tax-free income generated by Roth accounts. For this reason, it’s critical to understand the rules around withdrawing funds from Roth accounts to avoid taxes and early withdrawal penalties.
Key points to consider about Roth distributions1. Order of withdrawals
Unlike other areas of the tax code where distributions from certain retirement accounts or annuities consist of a pro-rata portion of income and contributions, the order of withdrawals from Roth IRAs differs. Distributions from Roth IRAs consist of contributions first, conversions (oldest to most recent) next, and finally earnings. Contributions can be withdrawn at any time, free of taxes and penalty.
2. “Qualified” Roth distributions are free of taxes and penalty
To be considered qualified, a distribution from a Roth account must meet BOTH of these criteria:
- Be established for at least five years AND
- Meet one of these conditions – the account owner must reach age 59½, or the withdrawal is the result of death, disability, or first-time home purchase (up to $10,000)
3. There are additional exceptions to avoid the 10% early withdrawal penalty
In addition to the exceptions discussed above (age 59 ½, death, disability, first time home purchase), non-qualified distributions can avoid the 10% penalty (but earnings are taxable) if one of these exceptions apply:
- Qualified higher education expenses
- Substantial equal period payments (SEPP), also referred to as 72(t) distributions
- Unreimbursed medical expenses that exceed 7.5% of adjusted gross income (AGI)
- Health insurance premiums if unemployed
- Qualified reservist distribution
- Qualified birth or adoption expenses (up to $5,000)
For Roth IRA contributions, the five-year period is based on the tax year when the first contribution applies, dated back to the beginning of the year. For example, assume John made a contribution on March 1 for the prior tax year. The five-year clock would start on January 1 of the previous year. For those with multiple Roth IRAs, the clock is based on when the first contribution occurred. For conversions, each will have its own five-year clock. However, if the owner has reached age 59½, for example, as long as the oldest conversion occurred at least five years ago, the distribution would be considered qualified (even if there are other conversions that occurred less than five years ago).* The separate five-year clock that applies specifically to conversions determines whether a non-qualified distribution of converted funds without an exception is subject to a 10% early withdrawal penalty. Within employer retirement plans, designated Roth accounts each have their own five-year clock. When a Roth 401(k) is rolled into a Roth IRA, the clock resets to zero, unless the individual has already established a Roth IRA.
5. Required distributions ARE required for some Roth accounts
One of the benefits of a Roth IRA is the ability to avoid required minimum distributions upon reaching age 72. However, due to a quirk in the tax code, required distributions must be made from designated Roth accounts (i.e., a Roth 401(k)). Plan participants with balances in a Roth 401(k) will want to roll those amounts over to a Roth IRA before reaching age 72.
Seek expert adviceIt’s important for investors to work with a tax consultant or financial professional who has knowledge of their personal financial situation. The rules around taking withdrawals from Roth IRAs are complex. To avoid taxes and penalties, it is important that taxpayers understand the rules and the specific timing and deadlines. Roth IRAs may be a helpful hedge against future higher tax rates, but only if they are managed wisely.
For more details on Roth IRAs and conversions, read our investor education piece, “Converting a traditional IRA to a Roth IRA.” For more information on Roth distributions, read this article, “Distributions from Individual Retirement Arrangements (IRAs).”
*Assumes account owner did not make any Roth IRA contributions previously.
For informational purposes only. Not an investment recommendation.
This information is not meant as tax or legal advice. Please consult with the appropriate tax or legal professional regarding your particular circumstances before making any investment decisions. Putnam does not provide tax or legal advice.