Contributions: Monies invested into a Roth IRA.
Original Contribution Date: January 1st of the original (first) Roth IRA contribution year.
Earnings (gains): Capital gains, passive income or dividends earned from a Roth investment.
Over the past few years, Bill’s wife, Julie, contributed $50,000 to her Roth IRA; since inception on 12/4/12, earnings from the investment total $36,000, for a total account balance to-date of $86,000. Bill received the Roth in a divorce settlement and immediately made withdrawals from the account. Note that had Julie not been ordered to give her IRA to Bill, the following guidance would be exactly the same for withdrawals made by Julie.
At any time, Bill can withdraw up to $50,000 (Julie’s total contribution), tax and penalty free. Brokers, by law, are required to report distributions in chronological order as: contribution amount first (always tax and penalty free), earnings second (see below for tax and/or penalty exemptions).
To cover his expenses, Bill needs to immediately withdraw both the original contribution of $50K and the $36,000 earnings that have accrued; again, the first $50K will automatically be reported tax and penalty free. Bill can withdraw the additional $36K earnings tax and penalty free, but only when two hurdles, both “A” and “B” below, are met:
A. The date of his wife’s first Roth contribution was > 5 years from the date of Bill’s first withdrawal of
the $36,000 earnings.
Bill’s wife opened her first Roth on 12/4/2012. Today’s date is 7/17/17. Although less than 5
years since her first Roth contribution, Bill would pass the 5 year rule.
Why? Because the IRS considers a Roth contribution anytime 1/1/12 through 4/15/13, to have originated
on 1/1/12 (retro start date). Therefore the 5 year clock began ticking as of 1/1/12 and the five year
rule was met on 1/1/17. A withdrawal of earnings on 7/17/17 would pass the 5 year rule.
B. Although Bill has passed the crucial 5 year test, one more hurdle must be passed for the $36,000 earnings
distribution to be tax and penalty free.
1. Bill was 59 ½ or older on the date or withdrawal, or
2. Bill is disabled (would need confirmation from the SSA), or
3. Bill uses the earnings for a first time home purchase (restricted to a maximum of $10,000)
• If both “A” and “B” above are satisfied, Bill can withdraw the $36,000 earnings tax and penalty
free. Again, “A” and “B” are not required for exemption of the first $50K withdrawn.
• When the 5 year rule has not been met, TAX would be due on the $36,000 earnings withdrawn, even if Bill
is over the age of 59 1/2.
When the 5 year rule is not met, tax will always be due on withdrawn earnings; however, the 10% early
withdrawal penalty can be waived in certain situations (see below).
Tom opened his first Roth on 9/4/14 when he was 57 years old; therefore, his 5 year clock began 1/1/14 (retro start date). On 5/5/17, Tom’s contribution balance was $15,000, with an earnings balance of $3,000 for a total of $18,000 total Roth balance.
At any time Tom could withdraw up to $15,000 with no penalty or interest being incurred. Although on 5/5/17 Tom is over the age of 59 ½, 5 years has not passed since Tom’s first Roth contribution date of 1/1/14 (retro date); therefore amy amount of Tom’s $3,000 Roth earnings, if withdrawn before 1/1/19, would be subject to tax (at the taxpayer’s tax bracket rate) and the 10% early-withdrawal penalty.
Note: when the 5 year rule has not been met, being disabled would not relieve Tom from owning tax or penalty on his $3,000 Roth earnings.
The 5 year test is the first, and most important, hurdle – without passing this test, and with no exceptions, Tom would owe tax on all amounts withdrawn in excess of his original Roth contribution.
When the 5 year rule is not met, tax will always be due on withdrawn Roth earnings; however, the 10% early withdrawal penalty can be waived under the following circumstances:
• The distributions are part of a series of substantially equal payments (minimum five years or until the
Roth IRA owner reaches age 59½, whichever is longer).
• When used to pay out-of-pocket medical expenses in excess of 7.5% of your Adjusted Gross Income (AGI).
• When used to pay medical insurance premiums after losing your job.
• When used to pay qualified higher education expenses (for yourself or eligible family members).
• The distribution is due to an IRS levy of the qualified plan.
• The distribution is a qualified reservist distribution.
• The distribution is a qualified disaster recovery assistance distribution.
• The distribution is a qualified recovery assistance distribution.