What are Ordering Rules
Ordering rules describe the order in which Roth IRA assets are distributed. Assets are distributed from a Roth IRA in the following order:
1. IRA participant contributions
2. Taxable conversions
3. Non-taxable conversions
Ordering rules are used when a distribution from a Roth IRA account is not a qualified distribution and thus, rules are needed to determine if and how much of the distribution qualifies for income taxation or an early distribution penalty. Ordering rules can help an individual determine how much of a distribution to take from a Roth IRA account or even what timing might be ideal to minimize penalties or fees.
BREAKING DOWN Ordering Rules
Ordering rules refer to the set of rules is used to determine the applicable tax treatment of a nonqualified Roth IRA distribution. Under the aggregation and ordering rules, all of an individual's Roth IRAs are treated as a single account. The IRS outlines a distribution hierarchy for assets within a Roth IRA account, which can be broken down by type of contribution. For example, contributions always come first, followed by any applicable conversions in order of year of contribution. Conversions within a Roth IRA account have their own set of rules, so converted pre-tax assets must be allocated first and converted after-tax assets second. One must also take into account if the conversations are taxable or non-taxable, with taxable conversions distributed first. Lastly, earnings are distributed.
Examples of Ordering Rules
While the hierarchy of ordering rules might appear straightforward, there are also specific governing rules regarding specific assets. For example, contributions are distributed tax and penalty free and converted pre-tax assets are distributed without being taxed or penalized, providing that they have been held in the account for five years. If the pre-tax assets have not been held in the account for at least five years, then a 10 percent fee would apply to the distribution. Converted after-tax assets, however, are always distributed tax and penalty free.
Further earnings are distributed tax and penalty free if the Roth IRA has existed for five years and the distribution is done on or after age 59 1⁄2, or following death, disability or first-time home purchase. Earnings outside of those circumstances will most likely be taxable and subject to a penalty, although penalty exceptions can be made in certain situations.
To visualize how ordering rules might work, consider M., who converted their traditional IRA to a Roth IRA. If M was under the age of 59 1/2 and wished to withdraw some of the earnings from the fund within the five-tax-year holding period, they would be subject to both an early withdrawal penalty as well as taxes.