Hello. My name is Chad Taylor, Managing Partner with MDT Financial Advisors here in Houston, Texas.
Roth IRAs are often seen as a preferred investment account because of the focus on the income tax-free distributions that are available. However, this is where a Roth IRA can become complicated. That's because the IRS rules around distributions from a Roth IRA are fraught with specifics. Depending on the status of each account and each owner, it pays to know the rules.
Roth IRAs have two types of distributions: qualified and nonqualified. Knowing the difference will help you understand if you will owe income tax on the distribution. You may owe a 10% additional tax on early distributions, meaning those taken before you are age 59 and a half, that are included in gross income.
Qualified distributions are tax-free and not included in gross income, occur when your account has been open for more than five years, and you are at least 59 and a half, or as a result of your death, disability, or using the first-time home buyer exception. The five-year waiting period for qualified Roth IRA distribution begins for all of your Roth IRAs on January 1st of the first taxable year for which the account was funded, and ends on December 31st of the fifth year. If, for example, you open a Roth IRA for the first time in 2020 and make a 2019 Roth contribution, that contribution is retroactive to January 1st, 2019, which is also when your five-year waiting period begins.
A nonqualified distribution is one that does not meet the above requirements. Does that mean nonqualified distributions are included in gross income? Not necessarily. Unlike traditional IRAs, there are ordering rules when taking nonqualified distributions from a Roth IRA. First, contributions come first. The first amount distributed from any of your Roth IRAs, if you have several accounts, are annual contributions. Because Roth contributions are not tax-deductible, they are not subject to tax or included in gross income and can be taken at any time.
Next, converted dollars are next. After you have exhausted all of your contributions, the next amounts distributed are from any conversions you have completed. These conversion amounts are distributed tax-free on a first-in, first-out basis. Converted amounts taken before the five-year holding period, or you are age 59 and a half or older, whichever is first, may have a 10% additional tax, and less than exception applies.
Earnings are last. The last amount is distributed from earnings. Earnings taken before the account has been open for longer than five years, and you are at least 59 and a half years or older, or you're disabled or the payment is made to your beneficiary after your death or using the first-time home buyer exception, are subject to income tax and the 10% additional tax, unless another exception applies.
So what are the exceptions to the 10% additional tax? The exceptions include distributions after you've reached age 59 and a half, death, disability, eligible medical expenses, certain unemployed individuals, health insurance premiums, qualified first time home buyer, there is a 10,000 lifetime maximum there, qualified higher education expenses, substantially equal periodic payments, Roth conversions, qualified reservist distributions, qualified birth or adoption expenses, or an IRS levy.
Did you know annual Roth contributions can be distributed at any time and are not subject to tax or included in your gross income? Now, keep in mind, you do not have to take required minimum distributions or RMDs from a Roth IRA during your lifetime, optimizing the opportunity to build tax-free wealth. If your spouse is the Roth IRA beneficiary, they will not have RMDs if they roll over or transfer the Roth IRA and treat it as their own. This allows for an additional period of tax-free compounding of potential earnings that can help grow your family's wealth. Beneficiaries can distribute earnings tax-free from an inherited IRA as long as the Roth has been funded for more than five years.
With you every step of the way. Everyone has a different vision of retirement that requires a unique financial strategy. Wells Fargo advisors can support you in your retirement planning process by providing the guidance needed to make informed choices. We will meet with you and help you create a comprehensive plan that takes into account your complete financial picture. Your financial advisor will be with you every step of the way to monitor your progress and adapt your plan as needed. Working together, we'll design and implement a retirement plan that can help you live out your unique vision of retirement. At Wells Fargo Advisors, we want to work closely with our investors in making wise choices for their future. To learn more about the Roth IRA and how it might fit your retirement planning needs, please contact your financial advisor with Wells Fargo Advisors. We look forward to helping you and your family plan your future retirement. Thanks and have a great day.