While you may think all Roth IRA withdrawals are tax-free. Think again!
Let’s review what you need to know about Roth IRA withdrawals for federal income tax purposes.
Roth IRA Accounts
Let’s first go over what a Roth IRA account is. A Roth IRA is an individual retirement account that is generally not taxed upon distribution as long as certain conditions are met.
However, when making contributions, you are limited to $6,000 (2022) or $7,000 if you’re over 50. Contributions are also limited by income. If you are a high-income earner, then Roth contributions are not allowed. Higher-income is defined as over $204,000 for married filing joint and $129,000 for single.
Since you are not taxed when you withdraw the contributions, they would be considered income the year you do contribute.
For example, if you earn $75,000 and contribute $6,000 to your Roth IRA, then that $6,000 is still considered taxable income.
On the contrary, if you earn $75,000 and contribute $6,000 to a traditional IRA, then the $6,000 becomes tax-deductible for that year. However, the $6,000 contributed to a traditional IRA is taxable when you withdraw the money later in life.
Therefore, you’ll start to see the benefits of a Roth IRA account. The contributions and earnings are tax-free as long as they are qualified withdrawals (I’ll cover that in a minute).
However, there are other retirement contribution options as a digital nomad or entrepreneur.
Roth IRA Withdrawals
To qualify as a tax-free withdrawal, you must be age 59 1/2 or older and had the Roth IRA open for at least 5 years.
If you’re under 59 1/2 years old, you are allowed to withdraw from a Roth IRA. However, you can only remove the original contributions and NOT the earnings.
If you remove the earnings and you’re under age 59 1/2, then you will be subject to the early withdrawal penalty of 10%. Surprise!
The five-year waiting period starts on January 1 of the first tax year for which you made a Roth IRA contribution. It can be a regular or conversion contribution.
That’s good news.
For example, you open a Roth IRA in 2015 by funding it in February 2016. Any time after January 1, 2020, you can withdraw the original funds or whatever funds you’d like if you’re 59 1/2 or over.
Roth IRA and Tax Reporting
When you have a qualified Roth IRA withdrawal, you will receive a 1099 R. Box 1 will show the amount of the withdrawal. Box 2 will oftentimes be left blank. When you complete your return, make sure to enter $0 as long as you meet the tests of having a Roth IRA for more than 5 years and you’re over 59 1/2.
If you meet the qualifications, then you would enter $0 for box 2 because the withdrawal is tax-free. Yay!
Box 7 provides the code that allows it to be tax-free. This is usually code Q.
Seems simple, right?
What if your withdrawal does not pass the qualifying tests?
Roth IRA Non-qualified Withdrawals
If you haven’t had the Roth IRA for 5 years, then your withdrawal will be subject to tax.
Remember if you’re over 59 1/2, then you can withdraw at any time from the Roth IRA as long as you’ve had the account for 5 years or more. However, if the account hasn’t been open for 5 years and you’re under 59 1/2, then you’ll owe the early withdrawal penalty of 10%.
This would be considered a non-qualified withdrawal. You’d complete Form 5329 to compute the penalty. This penalty amount would then show up on your 1040.
Avoid the penalty by making a qualified withdrawal from your Roth IRA.
How do you do this?
- Have the account for more than 5 years. AND
- Be over 59 1/2 OR
- Only make withdrawals of the original contribution and NOT the earnings if you’re under 59 1/2.
You can comply with these rules, right?
First-time Home Buyer Exception
If you pass the five-year test, then this will allow you to withdraw up to $10,000 for the purchase of a home. A first-time home buyer is someone who has not had any ownership in a principal residence within the two-year period that ends on the acquisition date.
Qualified costs include costs to acquire, construct or reconstruct a principal residence. This includes closing costs!
When you use this withdrawal, you will have a little extra paperwork. If box 7 of the 1099R reports code J (early distribution), then you’ll need to complete Form 8606. The total withdrawal amount gets entered on line 4a of your 1040. You would then enter the qualified home purchase expenses in Part III, line 20 of Form 8606.
Seems easy enough to comply with, right?!!?
If you’re under 59 1/2, your Roth IRA withdrawal could be taxed. This is only if you are withdrawing earnings and not the original contributions. Keep in mind you must have had the account open for 5 years or more.
If you’re over 59 1/2, then the earnings will not be taxed and you’ll have no early withdrawal penalty. Win-win, right!?!?
It’s important to understand there is no federal income tax on a qualified Roth IRA withdrawal. But you must be sure your withdrawal qualifies before taking out the money.
Planning to take a Roth IRA withdrawal? Reach out to your tax professional to be sure you won’t be taxed!