One of the benefits of a Roth IRA is the flexibility it gives in withdrawing your money before you reach age 59 ½ – the age at which you can take money out of other retirement accounts tax-free. Typically, if assets are removed prior to age 59 ½, the amount of the distribution is subject to a 10% early-withdrawal penalty tax unless another exception applies.
While this same rule applies to the earnings in a Roth IRA account, the total amount you have personally contributed over the years (known as the contributory basis) is always tax- and penalty-free, regardless of when you take a distribution. Here’s how to determine whether the distribution you take will be pulled from your personal contributions or earnings.
How ordering rules can impact your Roth IRA distribution
While you cannot choose if your Roth IRA distribution will be taken from basis or earnings, the IRS has set out a hierarchy of ordering rules.
Please be aware that these rules are applied to your Roth IRA assets as a whole, regardless of how many Roth IRA accounts you may have, even if they are at different financial institutions. You cannot avoid the rules by having one Roth IRA account that holds just conversion assets and another that has just the basis from your ordinary contributions.
Here is the order that applies to Roth distributions:
Contributory basis: The amount first applied will be what you have personally contributed each year. This amount will always be distributed tax- and penalty-free.
Additionally, any amounts you rolled over from a designated Roth account in an employer-sponsored plan will also be included in this amount. If at the time the rollover took place the distribution would have been a qualified distribution, the entire amount will be treated as contributory basis. If at the time the rollover took place the distribution would not have been considered a qualified distribution, the contribution amount will be considered contributory basis, but the earnings will be considered Roth IRA earnings.
Conversion amounts by year: The next portion of a Roth distribution will be pulled from any conversion you may have made from other accounts, starting with the oldest conversions first:
Taxable at time of conversion: This is any amount you converted from a non-Roth account, such as a traditional IRA or 401(k) plan, that was subject to taxation at the time of conversion. This amount is always distributed tax-free. However, if the distribution is not a qualified distribution, and it has not been at least five years since the conversion took place, it will be subject to the early-withdrawal penalty unless an exception applies.
Not taxable at time of conversion: This is the amount that you have converted from a non-Roth account, such as a traditional IRA or 401(k) plan, that was not subject to taxation at the time of conversion. These are typically non-deductible traditional IRA contributions and non-Roth after-tax amounts in a 401(k) plan. This amount will always be distributed tax- and penalty-free.
Earnings: Finally, any earnings you received on the amounts in the prior two categories will be distributed last. If the distribution is not a qualified distribution, the full amount will be subject to tax and the early-withdrawal penalty, unless an exception applies. However, if the distribution is a qualified distribution, the amount will be distributed tax- and penalty-free.
Examples of Roth IRA distributions based on ordering rules
Because Roth IRA ordering rules can be confusing, let's look at a few examples.
Example 1: A straightforward distribution
Tegan is 36 years old, does not have a penalty exemption, and has one Roth IRA that has been open since 2012. Here’s the breakdown of the account:
Roth IRA
$8,000 annual contributions
$2,000 earnings
Tegan takes a $9,000 distribution. To determine what portion of the distribution is subject to taxes and penalties, we need to look at the ordering rules:
Contributory basis: $8,000 - tax- and penalty-free
Conversion amounts: no assets of this type in the account
Earnings: $1,000 - included as taxable income and subject to 10% early-withdrawal penalty tax
The end result is that of the $9,000 taken, $1,000 of it will be included in taxable income and subject to the 10% early-withdrawal penalty tax.
After the distribution, the following will remain in the account:
$1,000 earnings
Example 2: A slightly more complex distribution
Vislor is 60 years old and has two Roth IRAs, with the first one opened in 2018.
Roth IRA A:
$2,000 annual contributions
$300 earnings
Roth IRA B:
$6,000 annual contributions
$1,700 earnings
Vislor takes a $9,000 distribution. Remember that it does not matter which account the distribution is taken from. When determining the tax and penalty repercussions of the distribution, the separate accounts will need to be treated as if they are a single Roth IRA.
Combined Roth IRA:
$8,000 annual contributions
$2,000 earnings
To determine what portion of the distribution is subject to tax and penalties, we need to look at the ordering rules:
Contributory basis: $8,000 - tax- and penalty-free
Conversion amounts: no assets of this type in the account
Earnings: $1,000 - would be included as taxable income except the distribution is a qualified distribution and is exempt from the 10% early-withdrawal penalty tax since Vislor is over age 59 ½
The end result is that the entire $10,000 distribution is tax- and penalty-free.
After the distribution, the following will remain in the account:
$1,000 earnings
Example 3: A complicated distribution scenario
Peri is 52 years old, does not qualify for a penalty exemption, has three different Roth IRA accounts, and their first Roth IRA contribution was made in 1998.
Roth IRA A:
$7,000 annual contributions
$5,000 earnings
Roth IRA B:
$5,000 taxed conversion asset (2022)
$5,000 not taxed conversion assets (2022)
$18,000 taxed conversion assets (2023)
$2,000 earnings
Roth IRA C:
$8,000 basis rollover from designated Roth that would have been a qualified distribution
$1,000 earnings rollover from designated Roth that would have been a qualified distribution
$500 earnings
Peri closes out Roth IRA B and takes a cash distribution of $30,000. Remember that it does not matter which account the distribution is from. When determining the tax and penalty repercussions of the distribution, the separate accounts need to be treated as if they were a single Roth IRA.
Combined Roth IRA
$7,000 annual contributions
$5,000 taxed conversion asset (2022)
$5,000 not taxed conversion assets (2022)
$18,000 taxed conversion assets (2023)
$8,000 basis rollover from designated Roth that would have been a qualified distribution
$1,000 earnings rollover from designated Roth that would have been a qualified distribution
$7,500 earnings
Next, we look at the ordering rules:
Contributory basis: $16,000 - tax- and penalty-free
This includes the $7,000 in annual contributions AND the $9,000 in rolled-over basis and earnings (rolled-over earnings are included because the rollover would have been a qualified distribution)
Conversion amounts:
2021 taxed conversion: $5,000 - tax-free but subject to 10% early-withdrawal penalty tax
2021 not taxed conversion: $5,000 - tax- and penalty-free
2022 taxed conversion: $4,000 - tax-free but subject to 10% early-withdrawal penalty tax
Earnings: None taken as the distribution amount was covered by the first two categories
The end result is that of the $30,000 taken, none of it will be included in Peri’s taxable income but $9,000 will be subject to the 10% early-withdrawal penalty tax.
After the distribution, the following will remain in the account:
Combined Roth IRA
$14,000 taxed conversion assets (2023)
$7,500 earnings
Who is responsible for identifying which portion of a distribution is subject to taxes?
Because Roth IRAs are individual accounts, it is your responsibility to keep track of what portion of your Roth IRA falls into each category.
The financial organizations holding the assets are not responsible for this determination. Additionally, since all Roth IRAs are aggregated for ordering rules purposes, the financial institutions often do not have the full information needed to make the determination.
Do these same ordering rules apply to Roth 401(k) distributions?
No. Roth 401(k) distributions do not have the same penalty exception or ordering rules. Roth 401(k) distributions are always a pro-rata portion of contributions and earnings.
This information is general in nature and is for informational purposes only. It should not be used as a substitute for specific tax, legal and/or financial advice that considers all relevant facts and circumstances. You are advised to consult a qualified financial adviser or tax professional before relying on the information provided herein.