Dear Gail,
I’m hoping you can clear up some confusion (and settle an argument!) over when you can take money out of a Roth IRA.

Two years ago I converted $20,000 from my regular IRA to my Roth. My friend says I can’t take this out for 5 years or I’ll have to pay a penalty. Is she right?

Thanks,
Lori

Dear Lori,

As it frequently is the case with tax issues, the answer is: it depends.

Withdrawals from a Roth IRA are subject to an ordering rule based on the source of the money. The first money from your first withdraw is assumed to come from annual contributions that you made to your Roth account.

Once you have withdrawn an amount equal to your total contributions, any additional money you take out is assumed to come from conversions.

When your withdrawals exceed the total of your contributions and conversions, the money taken out from your Roth IRA are earmarked as coming from earnings on the investments in the account.

How your withdrawal is categorized is critical—it determines whether you will have to pay a penalty.

Don’t worry, it’s not as complicated as it sounds.

For instance, suppose you have a Roth IRA worth $100,000 with the following breakdown:
Annual contributions to Roth IRA: $15,000
Conversion in 2002: 30,000
Conversion in 2005: 50,000
Earnings: 5,000

What are the consequences if you withdraw $25,000?

Based on the ordering rule, the first $15,000 withdrawn is assumed to come from your annual contributions. The next $10,000 is earmarked as coming from your earliest conversion.

Since annual Roth contributions are made with after-tax money and you paid income tax on the rest at the time you made your conversion, neither amount will be subject to income tax again when taken out. In fact, in the above scenario, you could take out as much as $95,000 income tax free. If you withdraw more than this, you would dip into earnings, which might be taxable depending upon the circumstances.

Assuming your withdrawal only includes contributions and conversion amounts, the main question is whether it would be subject to the 10% penalty tax.

The first thing to understand is that annual Roth IRA contributions can be withdrawn at any time without incurring a penalty. Theoretically, you could contribute to your Roth IRA today and take the money out tomorrow. Your withdrawal would not be subject to either the penalty or income tax (see above).

The tricky part is whether you’d owe a penalty if your withdrawal included converted amounts.

The key to this is your age. As with a traditional IRA, 59.5 is the equivalent of a “get-out-of-jail-free” card. Provided you are at least 59.5 years old, converted amounts can be withdrawn from a Roth IRA without penalty regardless of when you did the conversion.

But if you’re younger than that, Natalie Choate, a retirement and estate planning expert, says a 5-year holding period applies to converted amounts. Moreover, the holding period “applies to each conversion separately.”

In the above example, if you were to withdraw $55,000 from your Roth IRA, the first $45,000 are both income tax and penalty-free (since $15,000 is from your contributions and $30,000 is assumed to come from the conversion you made 6 years ago). However, you would pay a penalty on the next $10,000, which is from your 2006 conversion. To avoid a penalty on this money, you’d have to wait until 2011 to withdraw it.

Choate sums up the general rule this way: If you’re under age 59½ when you withdraw the money, “your conversion is penalty-free if wait 5 years.”

However, in addition to your age, there are a number of other circumstances that let you off the hook. These include:

1. You are disabled.
2. The IRA owner has died and you are the beneficiary.
3. You use the withdrawal to pay for qualified college expenses for yourself, your spouse, your children or grandchildren.
4. You have very high medical expenses that you have to pay for yourself.
5. You use the withdrawal to buy, build, or re-build a first-time home.
6. You lose your job and use the money to pay for health insurance.
7. You withdraw the money as an annuity.
8. You are a reservist called to active duty after 9/11/2001 and for at least 180 days.

In your case, Lori, you would have to pay a 10% penalty if: 1) you are under age 59.5, and 2) your withdrawal includes conversion dollars, 3) and one of the above exceptions does not apply.

IRS Form 5329 walks you through how to calculate what, if any, penalty applies to your Roth withdrawal.(8)

Hope this helps!
Gail

1. Choate points out that the 10% penalty would only apply to the amount that you had to pay income tax on when you made your conversion. For instance, say your traditional IRA included a mixture of tax-deductible contributions, after-tax contributions, and earnings you had not paid tax on.

If you convert the entire account to a Roth, you would only owe income tax on the amounts that had not yet be subject to tax, i.e. the tax-deductible contributions and pre-tax earnings.

Thus, if your Roth IRA withdrawal included converted assets and you did not qualify for an exception, the 10% penalty would only apply to the tax-deductible contributions and pre-tax earnings.

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.