Are Roth IRA Distributions Taxable?

Retirement is when a person makes the choice to leave the workforce for good. Leaving the workforce means you will not be making money from a job which can be a problem when it comes to your bills like rent, your phone bill, etc. The key to your retirement is proper planning. However, it can be hard to understand the best ways to get your retirement funds together before it’s too late.

Luckily, it can be easier to start saving for retirement than it may seem. That’s because there are a variety of different accounts available. People may not know that different accounts can help their retirement in different ways. Two options you will want to consider are Roth IRA accounts, and Traditional IRA accounts. Understanding what these two options can mean a world of difference when it comes to planning out your retirement.

What is a Roth IRA?

IRA stands for Individual Retirement Account. A Roth IRA is a type of account that allows qualifying Roth IRA withdrawals that meet certain conditions to be tax-free. A Roth IRA is different from a Traditional IRA. However, we will talk about that more later on in the article! A Roth IRA is funded with after-tax dollars. What does that mean? Well, Roth IRA contributions are not tax-deductible but once a person starts taking out funds, then they will be tax-free. The money in these accounts will grow tax-free as well. It’s important to note that a Roth IRA account is also less restrictive than other retirement accounts. That’s because the Roth IRA holder can maintain the Roth IRA forever, and there are no required minimum distributions (RMDs).

Understanding Roth IRA Distributions

Let’s take a deeper look at Roth IRA distributions. Roth IRA distributions are known as Roth IRA withdrawals. You can take out Roth IRA contributions from your Roth IRA without having to worry about taxes and penalties. For example, if you withdraw the same amount of money that you have deposited then the distribution (the amount you take out) is not considered taxable income. On top of that it is not subject to penalty no matter who old you are or how long you had the funds in the account. However, there are two types of distributions!

It’s important to note that there are still some things that you will need to keep in mind. One key part of Roth IRA distributions is any returns that the account generates. In order for a distribution to be considered qualified, it will need to have happened at least 5 years after the Roth IRA holder created and funded their first Roth IRA. On top of that, the distribution must also happen under at least one of the following examples:

  • The Roth IRA holder is at least 59 years and 6 month old when the distributions happen.
  • Assets that are distributed are used towards building, buying, or rebuilding a first home for the Roth IRA holder or an eligible family member. Eligible family members include the Roth IRA holder’s spouse, a child of the Roth IRA holder, a child of the Roth IRA holder’s spouse, a grandchild of the Roth IRA owner, etc. (the limit is $10,000 per lifetime).
  • The distribution happens once the Roth IRA holder becomes disabled.
  • Assets that are distributed to the beneficiary of the Roth IRA holder once they pass away.

Are Roth IRA Distributions Taxable?

We want to answer the question, “Are Roth IRA Distributions Taxable?” as clearly as we can! Like we said earlier in this article, Roth IRA distributions are tax-free. However, that is only if they are qualified distributions. If they are not qualified distributions then it is a different story. Non qualified distributions that do not meet the conditions listed above may have to deal with income tax and/or a 10% early withdrawal penalty. There are exceptions to this tax and penalties if the funds go towards any of the following:

  • Unreimbursed Medical Expenses: The distribution must exceed 7.5% of the person’s adjusted gross income (AGI) for the 2021 tax year (and tax years prior).
  • Paying Medical Insurance: Only if the person lost their job.
  • Towards Qualifying Higher Education Costs: Qualifying higher education costs include tuition, fees, supplies, books, and more for the Roth IRA holder and/or their dependents. Eligible items must be a requirement in order to enroll or attend as a student at a qualifying educational institution. The funds must be used in the year that they are taken out!
  • Towards Adoption Expenses or Childbirth Expenses: Only if the distribution was made within one year of the event and is not over $5,000.

Do You Have to Report Your Roth IRA on Your Tax Return?

It’s important to keep in mind what we said earlier in this article. Roth IRA accounts are funded with after-tax dollars. That means you will pay taxes on the funds you put in when you deposit them. Roth account contributions are not tax-deductible. On top of that, qualified distributions are not taxable income. That means you will not report them on your return!

What is a Traditional IRA?

Besides a Roth IRA, another retirement account to consider is a Traditional IRA. This type of account is an option that allows people to use pre-tax income towards investments that can grow as tax-deferred. The Internal Revenue Service (IRS) determines no capital gains or dividend income taxes until the beneficiary makes a withdrawal. The funds can only be tax-deferred if they are withdrawn when the account holder is 59 years and 6 months old or later. Qualifying individuals that pay taxes (also known as taxpayers) can contribute all of their earned compensation up to a specific maximum amount of funds. There are income thresholds that apply which are important to keep in mind.

Unlike a Roth IRA account, Traditional IRA contributions are generally tax-deductible. However, whether or not it will be tax-deductible depends on factors like the tax-filing status, the taxpayer’s income, etc. People that are saving for retirement can open up one of these accounts through their broker or financial advisor. The IRS will limit how much a person can add to this type of account every year depending on age. For example, the contribution limit for 2021 (and 2022) is $6,000 for people that are less than 50 years old. For those that are over 50 years old, they have a higher contribution of $7,000.

What’s the Difference Between a Roth IRA and a Traditional IRA?

While both of these retirement account options can provide tax breaks, they are not the same. There are some key differences between these accounts. The biggest differences come down to how these accounts handle withdrawals (distributions) and deposits (contributions).

Commonly Asked Questions

Understanding Roth IRA distributions can be confusing. Especially for people who aren’t familiar with planning for retirement. Other people learning about this topic have had questions that you may find yourself to have too!

Will You Need to Deal with Income Tax on a Roth IRA Withdrawal?

If you do not take out a qualified distribution then you may be responsible for paying an early withdrawal penalty. Besides dealing with an up to 10% early withdrawal penalty, you will have to worry about potentially paying income tax as well.

What Types of Roth IRA Distributions are Tax-Free?

In order for a Roth IRA distribution to be considered tax-free, the distribution will need to have occurred at least 5 years after the Roth IRA holder created and funded their first Roth IRA. On top of that, the distribution must also happen under at least one of the following examples:

  • The Roth IRA holder is at least 59 years and 6 month old when the distributions happen.
  • Assets that are distributed are used towards building, buying, or rebuilding a first home for the Roth IRA holder or an eligible family member. Eligible family members include the Roth IRA holder’s spouse, a child of the Roth IRA holder, a child of the Roth IRA holder’s spouse, a grandchild of the Roth IRA owner, etc. (the limit is $10,000 per lifetime).
  • The distribution happens once the Roth IRA holder becomes disabled.
  • Assets that are distributed to the beneficiary of the Roth IRA holder once they pass away.

Understanding Non-Qualified Distributions

If the distribution doesn’t meet any of these conditions then they will be considered a non-qualified distribution. That is when Roth IRA distributions are taxable. Non qualified distributions are the ones that could potentially deal with income tax and an up to 10% penalty. There are exceptions when it comes down to whether or not Roth IRA distributions are taxable.  Exceptions include if the funds go towards any of the following:

  • Unreimbursed Medical Expenses: The distribution must exceed 7.5% of the person’s AGI for the 2021 tax year (and tax years prior).
  • Paying Medical Insurance: Only if the person lost their job.
  • Towards Qualifying Higher Education Costs: Qualifying higher education costs include tuition, fees, supplies, books, and more for the Roth IRA holder and/or their dependents. Eligible items must be a requirement in order to enroll or attend as a student at a qualifying educational institution. The funds must be used in the year that they are taken out!
  • Towards Adoption Expenses or Childbirth Expenses: Only if the distribution was made within one year of the event and is not over $5,000.

What are Substantially Equal Periodic Payments?

Unless you are eligible for an exception, taxable amounts that you take out of an IRA or qualifying retirement plan before the age limit of 59 year and 6 months old may deal with the taxes and penalties we listed above. However, there are exceptions to these tax penalties. One exception involves taking a series of “substantially equal periodic payments” (SEPPs) from your IRA.

These payments are funds that you must take out of your IRA. You must use an IRS-approved distribution method and take at least one distribution every year. There are multiple IRS-approved methods for figuring out the amount of these payments that rely on factors like your life expectancy (amongst other factors). The payments must continue until you are at least 59 years and 6 months old or for at least 5 years, whichever is later.

What Happens if You Early Withdrawal Funds from Your Roth Account?

If you take out an early withdrawal from your Roth account, you may be responsible for paying income tax. That even includes state income tax! Other than that, you may need to deal with an early withdrawal penalty of up to 10%. While we may sound like a broken record, people can ask this question in a lot of different ways so we want to make sure we can provide as much information as possible!

Bottom Line

Planning for retirement can be scary. There are plenty of options to consider. One account that people use is a Roth IRA. A Roth Account is a type of retirement account that allows qualifying Roth IRA withdrawals that meet certain conditions to be tax-free. This account is different from a Traditional IRA due to how these accounts handle withdrawals (distributions) and deposits (contributions).

A Roth IRA is funded with after-tax dollars. What does that mean? Well, the Roth IRA contributions are not tax-deductible but once a person starts taking out funds, then they will be tax-free. The money in these accounts will grow tax-free as well. It’s important to note that a Roth IRA account is also less restrictive than other retirement accounts. That’s because the account holder can maintain the Roth IRA forever, and there are no required minimum distributions (RMDs).

Understanding the Qualified Distributions

Roth account distributions are tax-free. However, that is only if they are qualified distributions. In order for a distribution to qualify, it will need to have happened at least 5 years after the Roth IRA holder created and funded their first Roth IRA. On top of that, the distribution must also occur under at least one of the following:

  • The Roth IRA holder is at least 59 years and 6 month old when the distributions happen.
  • Assets that are distributed are used towards building, buying, or rebuilding a first home for the Roth IRA holder or an eligible family member. Eligible family members include the Roth IRA holder’s spouse, a child of the Roth IRA holder, a child of the Roth IRA holder’s spouse, a grandchild of the Roth IRA owner, etc. (the limit is $10,000 per lifetime).
  • The distribution happens once the Roth IRA holder becomes disabled.
  • Assets that are distributed to the beneficiary of the Roth IRA holder once they pass away.

Understanding the Non-Qualified Distributions

If they are not qualified distributions then it is a different story. Non qualified distributions that do not meet the conditions listed above may have to deal with income tax and/or a 10% early withdrawal penalty. There are exceptions to this tax and penalties if the funds go towards any of the following:

  • Unreimbursed Medical Expenses: The distribution must exceed 7.5% of the person’s AGI for the 2021 tax year (and tax years prior).
  • Paying Medical Insurance: Only if the person lost their job.
  • Towards Qualifying Higher Education Costs: Qualifying higher education costs include tuition, fees, supplies, books, and more for the Roth IRA holder and/or their dependents. Eligible items must be a requirement in order to enroll or attend as a student at a qualifying educational institution. The funds must be used in the year that they are taken out!
  • Towards Adoption Expenses or Childbirth Expenses: Only if the distribution was made within one year of the event and is not over $5,000.

Article References

https://www.investopedia.com/terms/r/retirement.asp

https://www.investopedia.com/terms/r/rothira.asp

https://www.hrblock.com/tax-center/income/retirement-income/reporting-roth-ira-contributions/

https://www.investopedia.com/terms/t/traditionalira.asp

https://www.investopedia.com/retirement/roth-vs-traditional-ira-which-is-right-for-you/

https://www.theretirementgroup.com/blog/substantially-equal-periodic-payments-an-exception-to-the-premature-distribution-tax

Previous articleShould I Be a Contractor or Employee?
Next articleDifferent Financial Relief Opportunities for Families