Here’s what happens when you take a Roth IRA distribution that doesn’t qualify to be tax-free.
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The basic idea behind Roth IRAs is to take only distributions that qualify for exemption from tax. Inevitably, though, some people will need to take taxable distributions. This page explains how these distributions are taxed, and what circumstances will permit you to avoid the penalty on early distributions.
You don’t pay tax on your Roth IRA distributions until you withdraw earnings, and you aren’t considered to be withdrawing earnings from your Roth IRA until the total amount you’ve withdrawn from all your Roth IRAs is greater than the total amount you contributed to all your Roth IRAs, including rollover contributions. If you meet certain requirements, you won’t pay tax when you withdraw earnings. But if you don’t meet those requirements, you’ll have to pay tax on the earnings you withdraw, and you may have to pay a penalty, too.
Distributions taxed as ordinary income
If your distributions are taxable, you’re required to treat them as ordinary income. You can’t treat them as capital gain, even if the IRA received the earnings as capital gain.
Example: You contributed $2,000 to a Roth IRA and invested it in stock. Three years later, when the stock is worth $3,000, you direct the trustee to sell the stock and distribute the entire $3,000 to you. Result: you must report $1,000 of ordinary income. The result would be the same if you directed the trustee to distribute the stock to you (instead of selling it and distributing the cash).
Distributions without penalties
If you withdraw earnings, and the withdrawal is not a qualified distribution, you need to determine whether the withdrawal will be subject to the 10% early distribution penalty.
Withdrawals that meet the “type of distribution” test for qualified distributions are not subject to the 10% penalty even if you withdraw these amounts less than five years after establishing your Roth IRA.
Example: You contributed $2,000 to a Roth IRA. Two year later, when you are over age 59½, you withdraw the $2,000 plus $400 earnings. You pay no tax or penalty on the first $2,000, which represents your contribution to the Roth IRA. You must pay tax on the remaining $400 because you didn’t satisfy the five-year test. But no penalty applies because you’re over age 59½.
In addition to the four qualified distribution categories (age 59½, death, disability, first-time homebuyer), you can receive distributions without penalties if any of the following are true:
- You have unreimbursed medical expenses greater than 7.5% of your adjusted gross income.
- You pay medical insurance premiums after losing your job.
- You receive distributions that are part of a series of substantially equal payments over your life (or life expectancy).
- You pay qualified higher education expenses for yourself, your spouse, your children or your grandchildren.
Example: You withdraw money from a Roth IRA to pay qualified higher education expenses for your child. You pay no tax until the total amount you withdraw exceeds the total amount of your contributions. You pay tax on any additional amount you withdraw, but you don’t pay a penalty because the money is used for qualified higher education expenses.
When taxes and penalties apply
If you receive a non-qualified distribution of earnings from an IRA and don’t meet any of the tests described above, you must pay two taxes: the regular income tax plus an additional 10% early withdrawal penalty tax.
Example: You contributed $2,000 to a Roth IRA. Three years later you withdraw the $2,000 plus $400 earnings to buy a new computer. You’re under age 59½ and no exceptions apply. If you’re in the 22% tax bracket you’ll pay $88 regular tax (22% of $400) plus $40 early distribution tax ($10% of $400). You pay no tax or penalty on the $2,000 that represents your contribution.