What Are Roth Ordering Rules?
The Roth ordering rules govern the way in which money in a Roth individual retirement account (IRA) is withdrawn and therefore determine whether any income taxes are due.
The account holder does not have to specify this order. It is automatically handled by the company that manages the funds.
Assets are distributed from a Roth IRA in the following order:
1. IRA participant contributions
2. Taxable conversions
3. Non-taxable conversions
Understanding Roth Ordering Rules
A Roth IRA, by definition, is a retirement savings vehicle that is tax-free in retirement. That is, the account holder pays the income taxes due during the year in which the money is deposited in the account. No further taxes are due on the principal or earnings when qualified distributions are taken.
The key phrase is "qualified distributions."
Ordering rules are used when a distribution from a Roth IRA account is not a qualified distribution. For instance, taxes may apply if money is withdrawn from the account too early.
Thus, rules are needed to determine if and how much of the distribution qualifies as taxable income or is subject to an early distribution penalty.
Knowing the ordering rules can help an individual determine how much cash can be taken from a Roth IRA account and even what timing might be ideal to minimize penalties or fees.
The Rules In Depth
Under the aggregation and ordering rules, all of an individual's Roth IRAs are treated as a single account. That is, if a person has multiple IRA accounts, the IRS treats them as a single fund.
The Internal Revenue Service (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 are allocated second. One must also take into account if the conversations are taxable or non-taxable, with taxable conversions distributed first. Earnings are distributed last.
Examples of Ordering Rules
There are also rules regarding specific assets. For example, contributions are distributed tax-free 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 or more.
If the pre-tax assets have not been held in the account for at least five years, then a 10% fee would apply to the distribution.
Converted after-tax assets, however, are always distributed tax-free and penalty-free.
Further earnings are distributed tax-free and penalty-free if the Roth IRA has existed for five years and the distribution is done on or after age 59 ½, or following death, disability, or a 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 a person who converted a traditional IRA to a Roth IRA. If the person was under age 59 ½ and wished to withdraw some of the earnings from the fund within the five-tax-year holding period, the money would be subject to both an early withdrawal penalty and taxes.