When are investment gains from Roth IRA's taxable?
Are the investment gains from Roth IRA's taxable after distributions of the portion which was contributed?
If you are age 59.5 or older, no part of the distributions from a Roth IRA is taxable. Before then, you can withdraw the contribution amount tax-free, however if you tap into the earnings portion, you will be subject to taxes, and possibly penalty.
To put your mind at ease—your Roth IRA account is a tax-exempt account, under the current law, which means your contribution as well as your earnings will be tax free at your retirement time.
However, there are a couple of caveats: 1) When you withdraw too early from a contributory IRA or converted Roth, without being qualified of any of the IRS prescribed exceptions, your earning portion in the contributory IRA or your original converted amount to the Roth account could by subject to taxation, regular income tax, 10% penalty tax, or both.
2) When your investments in the Roth generate the so-called unrelated business income, you’re subject to the UBIT (unrelated business income tax). Case in point: leveraged Real Estate Investments. When you use a portion of your IRA (Roth or traditional) to purchases real estate investments with a non-recourse mortgage loan, the profit from the debt financed portion of the property, in the eyes of IRS, is the “unrelated business income”. Consequently, you will be paying the UBIT. Another example is the MLP (Master limited partnerships). Each year thousands of investors who hold MLPs in their IRAs are caught off guard about the taxation when they receive that nasty 1099 the following year. It’s a painful reminder that you need to understand what you invest and the tax consequences. I hope you choose your investment and advisor wisely in helping your own financial matters. Best!
Unlike taxable accounts, gains inside a Roth IRA are not taxable. Therefore, you will not receive a 1099 showing any capital gains, interest or dividends to report on your tax return. Unlike tradional IRA's, Roth IRA distributions are not taxed at distribution either. Contributions to a Roth IRA's are made with after[-money assuming you are income eligible to make them.
That’s a great question. The answer depends on a number of factors. Let’s first start by reviewing how the IRS classifies each withdrawal and what is considered taxable versus non-taxable, or penalty free.
The IRS looks at Roth IRA distributions in this order utilizing the first-in-first out rule.
2. Conversion contributions
3. Earnings on your contributions.
Regardless of your age, how long the funds have been in your Roth IRA or the purpose of the withdrawal, the total amount of your Roth IRA contributions can be withdrawn at any time, tax and penalty free. That means you need to keep good records as to the total amount of contributions you have made and the date of your very first contribution.
Next comes withdrawals from Roth conversions. The total amount of conversion contributions are also considered tax free unless it has been less than five years since the conversion, in which case the withdrawal may be free from federal income taxes, but you still may be hit with a 10% penalty.
Note: To ensure withdrawals of your contributions and/or Roth conversion amounts are not taxed you need to file IRS Form 8606 along with your 1040 for the tax year the funds are withdrawn.
With that background information in place, we can now begin to answer your question regarding when and how withdrawals that are considered earnings in excess of your contributions are taxed.
The short answer is, it depends. Withdrawals of earnings from your Roth IRA are also tax-free unless:
- You make a withdrawal of earnings prior to age 59 ½. These would be considered nonqualified withdrawals and any earnings would be subject to both federal income tax and a 10% penalty unless you're eligible for an exception.
- It has been less than five years since your first Roth IRA contribution. (Regardless of how many Roth IRA accounts you may have)
(Roth 401k's have their own 5-year clock and Roth IRA Conversion’s five year clock begins on January 1st for the year the conversion was done, Inherited RothIRA's five year clock starts on the original account owner’s contribution date)
Click here to learn more about the five-year rule.
If you make a withdrawal in excess of your contributions before the five-year mark, it would also be considered a nonqualified withdrawal, and as such, it may be subject to income tax and a 10% penalty if you are under the age of 59 ½, unless you're eligible for an exception.
Here are the two exceptions to the tax rules as noted above:
- Home Purchase Exemption
If you've passed the five-year test but you're under 59½, a special exception allows tax-free and penalty-free Roth withdrawals in order to buy a principal residence. However, there's a lifetime $10,000 limit with this exception. (You and your spouse can exempt up to $20,000), and you must use the money within 120 days of the withdrawal. The homebuyer can be you or certain relatives (including kids and grandkids). However, the buyer must not have owned a principal residence within the two-year period ending on the purchase date.
If you become disabled before you reach age 59½, any distributions from your Roth IRA because of your disability are not subject to the 10% additional tax, but may still be subject to income taxes if the five year rules noted above are not met.
According to the IRS: You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued, and indefinite duration.
Note: The information provided above is for educational purposes only and is not intended to provide, and should not be relied on for tax, legal or accounting advice. Representatives of Signator Investors, Inc. do not provide tax and legal advice. Please consult your tax advisor or attorney for such guidance.