Roth IRAs are a great way to balance out your retirement portfolio with assets that can offer a tax-free source of income. Specific rules governing distributions that enhance tax breaks—and a growing list of exceptions to early penalty rules—make Roth IRAs a handy asset to have in your investment toolbox.

The biggest and best-known advantage of a Roth IRA is that distributions of contributions and nontaxable conversions to a Roth can be taken tax-free and penalty-free at any time, at any age with no waiting period. If your Roth has been in place for five years and you have reached age 59½, earnings can be drawn out tax- and penalty-free as well. 

The good news is that under rules that specify the order in which assets are used when withdrawing from a Roth IRA, the tax- and penalty-free contributions are distributed first. When those are all paid out, any assets from taxable IRA to Roth conversions or rollovers are distributed, followed by nontaxable conversion assets. Finally, earnings on all IRA assets are distributed last. 

This first-in, first-out rule may give taxable assets and earnings time to mature into qualified distributions that will not add to taxable income. To minimize your Roth IRA taxes and maximize the benefits of tax-free gains, it’s important to keep this order in mind. 

However, non-qualified distributions of funds converted from a traditional IRA to a Roth may be subject to a 10 percent penalty for withdrawing from the Roth IRA early. A non-qualified distribution of earnings could be subject to taxes and the penalty.

To count as a qualified distribution and avoid penalties, the withdrawal must occur at least five years after the owner funded his or her first Roth. The recipient of the distribution must be:

  • at least age 59 ½; 
  • disabled;
  • a beneficiary who inherited the Roth; or
  • using a withdrawal of up to $10,000 for the purchase or rebuilding of a first home for the owner or a qualified family member (a spouse, child or their spouse, grandchild or their spouse, or a parent of the Roth owner). 

Additional exceptions allow penalty-free early withdrawals to pay educational costs, high medical expenses, or healthcare premiums after losing a job, adoption expenses, disaster recovery costs, and a few other special circumstances. Access to after-tax funds for these special needs uses make a Roth IRA an even more valuable, flexible part of your investment portfolio. 

Understanding the order in which assets will be drawn from an IRA helps optimize the timing and size of distributions. A large withdrawal that exceeds remaining contributions and dips into recently converted funds could incur a penalty, for example. Likewise, drawing down to the point where you’re taking out earnings in less than five years will incur taxes and a penalty unless one of the exceptions apply. Contact us today to learn more. 

  • Toni Shears