How Do Roth IRA Withdrawals Affect Your Tax Situation?

Some withdrawals from a Roth IRA are taxed, despite popular belief. A 10 percent early withdrawal penalty tax can be applied even if there is no income tax due. This is the worst-case scenario.

Take a look at the information below to learn more about tax-free Roth IRA withdrawals. To begin, let’s look at the most basic scenario.

A Few Simple Rules Apply to Qualified Withdrawals

If you possess a Roth IRA, you can make tax-free withdrawals from any of your Roth accounts if you meet certain requirements.

  • at least 59 1/2 years of age and
  • more than five years’ worth of Roth IRAs is open.

Withdrawals are generally free of state income tax. Good!

To be eligible for a qualified withdrawal, you must pass both the age test and the five-year test. Withdrawals must be made within five years after making a Roth contribution for them to be considered eligible. It might be a one-time donation or a recurring yearly donation.

Qualified Withdrawal Tax Reporting

The IRA trustee or custodian should issue you a Form 1099-R when you make a qualified Roth withdrawal.

The gross amount of the withdrawal should be reported in Box 1 of Form 1099-R.

A check-in box 2b indicates that the trustee or custodian has not determined the zero taxable amount. A Q code in box 7 suggests that the distribution is qualified and free of federal income tax.

Form 1040 line 4a asks for the total amount of your qualified withdrawals. To avoid paying federal income tax on a qualified withdrawal, enter zero on line 4b.

The Non-Qualified Withdrawal Rules Are Not as Straight-forward as You Might Think

A non-qualified withdrawal may be taxed if it’s made from an IRA or similar account. If you remove money from your retirement account before the age of 59 1/2, you may be hit with a 10% early withdrawal penalty tax.

To make things a little clearer, we’ll look at two different scenarios for non-qualified withdrawals.

  1. Those withdrawals made before the age of 59 1/2 are not eligible.
  2. Non-qualifying withdrawals made before the five-year test has been completed.

Scenario 1: Withdrawals Made Before The Age of 59 1/2 are Not Eligible

Any Roth withdrawal before the age of 59 1/2 is, by definition, a non-qualified withdrawal. There are just a few exceptions to this rule.

  • if the special provision for first-time homebuyers is applicable,
  • When the person who created the account has passed away or disabled

In the event of a non-qualified withdrawal, both federal income tax and the 10 percent early withdrawal penalty may be owed.

There are four possible sources of a non-qualified withdrawal. Each level of the tax structure has its own set of federal income tax regulations.

The most important thing to keep in mind. To figure out where each withdrawal originates from and the accompanying federal income tax ramifications, you must combine all of your Roth IRAs and treat them as one.

Scenario 2: Non-Qualifying Withdrawals Made Before The Five-Year Test Has Been Completed

There are four layers of protection in place for non-qualified withdrawals, which are the same as the ones in Scenario 1.

The most important thing to keep in mind. There is no 10% penalty tax on withdrawals made after age 59 1/2, becoming disabled, or dying in this failed five-year test scenario.

Reminder. Every time you withdraw money from one of your Roth IRAs, you must figure out where the money came from and what the federal income tax consequences will be.

Non-Qualified Withdrawal Tax Reporting

A Form 1099-R will be issued by the IRA trustee or custodian when you make a non-qualified Roth withdrawal, just as you will if you make a qualified withdrawal. The gross amount of the non-qualified withdrawal should be reported in Box 1 of your Form 1099-R. Box 2b is usually marked to show that the trustee or custodian has not determined the taxable amount.. Box 2a can be used if the trustee or custodian understands the taxable amount.

A distribution code T (Exception applies) in Box 7 of Form 1099-R indicates that the trustee or custodian understands the 10% penalty tax is not due because you were 59 1/2 years old or older, handicapped at the time of the non-qualified withdrawal, or deceased at that time.

If the trustee or custodian believes the 10% penalty tax is due, they should enter J in Box 7 of Form 1099-R (early distribution).

Bringing It All Together.

A qualifying Roth withdrawal is free of federal income tax. Before making a withdrawal, check certain it’s eligible for tax purposes.

Withdrawals from non-qualified Roth IRAs are subject to special tax regulations. The good news is that when you correctly complete IRS Form 8606 Part III and put the correct amount (which may be zero) on line 4b of your Form 1040, everything falls into place as you expected.

There’s also the 10% early withdrawal penalty tax to consider for non-qualified withdrawals, which you’ll need to do on IRS Form 5329 if it applies.

If you’re thinking about making another large non-qualified Roth IRA withdrawal this year, talk to your tax advisor and get his or her advice on the front and back ends of your withdrawal process.

What do you think? Would you like someone to manage your financial issues on your behalf? Click this link and it will take you to our online reservation system where you may talk with one of our staff and obtain a free first consultation. Hopefully, we’ll run across each other there!

Scroll to Top