Avoid Costly Mistakes By Understanding Roth Ordering Rules
Roth IRAs are known for their beneficial flexibility but if you have one then it's important to know that there are rules that govern how money is withdrawn and taxed.
These rules are called "ordering rules" and apply to non-qualified distributions* that don't meet the standard requirements.
The rules require withdrawals to be done in this order:
Participant IRA contributions
Taxable conversions
Non-taxable conversions (e.g. Backdoor Roth)
Earnings
Let’s get into them.
Non-Qualified distributions from a Roth IRA DO NOT meet the following criteria: satisfy the 5-year rule (it’s been at least 5 years since you first contributed to your Roth IRA), made on or after the date you turn 59.5, taken because you have a permanent disability, made by a beneficiary of your estate after your death, or used to buy, build, or rebuild your first home for which a $10,000 lifetime max applies.
1. Participant Contributions
This is the first money that's withdrawn from a Roth IRA. These are your regular contributions that were directed straight to the IRA.
These distributions are always tax and penalty free because you've already paid tax on the contributions. This is perhaps one of the biggest draws of the Roth IRA. You still retain access to your contributions if needed but also you’re earnings are growing tax-free.
2. Taxable Conversions
The second to be withdrawn is taxable conversions, oldest to newest, if they exist.
These conversions represent money that has been converted, and taxed, from pre-tax money. For example, if you were to convert some of your Traditional IRA money, which you received a deduction for and but hasn’t been taxed, to your Roth.
These distributions are penalty free (granted you satisfy the 5-year rule).
The 5 year-rule states that conversion must age 5 years before being withdrawn. The 5-year period for a conversion starts January 1st for the year of conversion. So if you made a conversion on October 15th of a specific year then the actual conversion date would be January 1st of that same year.
Each conversion has its own 5-year rule that must be satisfied in order to avoid taxes and penalties.
3. Non-taxable Conversions (e.g. Backdoor Roth)
Third step in the order is non-taxable conversions, oldest to newest, if they exist. These are conversions where no taxable event was triggered such as a backdoor Roth.
Remember, a backdoor Roth involves making after-tax, non-deductible contributions to a Traditional IRA and then converting those contributions to a Roth IRA. This is a strategy for high earners to sidestep the income limitation requirements to contribute to a Roth IRA.
Because these contributions were already taxed (after tax), any distributions from this group are tax and penalty free.
4. Earnings
The last type of money to be withdrawn is earnings, or the growth on your contributions and/or conversions.
Earnings can be withdrawn tax and penalty free by withdrawing after age 59.5 AND only after satisfying the 5 year rule pertaining to earnings.
In this case, it needs to have been at least 5 years since you first contributed to a Roth IRA. January 1st is always used as the start date for contributions made THAT YEAR. So if you first contributed to a Roth IRA in 2018 then you would be eligible to withdraw any earnings, tax and penalty free, anytime after January 1, 2023 as long as you’re at least age 59.5.
As you can see, it can get pretty dicey following all the rules. But it's important so you can avoid any unnecessary taxes and penalties! This makes it paramount to accurately track your contributions (also known as basis), conversions, and all relevant dates.
