Real Tacos Can Not Contain Eggplant - A Guide to Roth Distributions
Amy Walls of Thimbleberry Financial likes to talk about "rainy" and "sunny" times when it comes to personal finance. Taking distributions from a Roth account can be one of the sunny times, if you follow the rules.
First we recap the ways we can contribute to a Roth IRA. They are:
- Contributions – annual contribution put directly into a Roth IRA. Directly is the key word here.
- Conversions – This is money put into a traditional IRA, or 401(k) or 403(b) and then converted into a Roth. There are two types:
- Pre-tax: an employer plan that is rolled over into a Traditional IRA or Rollover IRA that is later CONVERTED to a Roth IRA.
- Non-Taxable Conversion: This is the strategy we’ve talked about before that is often referred to as a Back-Door Roth. Contributions are made after-tax to an IRA, and then CONVERTED to a Roth IRA.
- Rollover of a designated Roth account – This is when your employer allows you to
- Contribute after-tax money to your 401k or 403b as a Roth designated contribution. Not all employers do this.
- Earnings: This is growth on the money inside the account.
Now we can look at the ways in which money is distributed out of a Roth account, keeping in mind the acronym "Real Tacos Can Not Contain Eggplant."
Assets are distributed in the following order:
1. Regular Roth IRA participant contributions, includes rollovers of directly contributed Roth 401(k) and 403b dollars.
2.Taxable Conversion and rollover amounts- Pre-tax IRA contributions or an old employer plan that is converted.
3.Non-taxable Conversion and rollover amounts - After-tax IRA contributions and internal 401k conversions (Mega backdoor Roth)
4.Earning on Roth assets- Growth.
For illustrative purposes, Amy gives an example of these. Here it is, laid out.
Sara opened a Roth IRA in March 2019 and makes contributions for 2018 and 2019. The 2018 contribution treats the account as if it were opened on January 1, 2018. In 2019 she converted a $35,000 Traditional IRA to a Roth IRA. Sara is 57 years old at the end of 2020. The account contains:
- $15,000 in contributions for 2018, 2019, and 2020.
- $30,000 taxable traditional IRA coversions from 2019.
- $5000 of non-taxable Roth IRA conversions from 2019.
- $5000 in earnings.
- $55,000 TOTAL
Let’s say Sara wants to take a $52,000 distribution.
- Sara can take up to $15,000 without taxes and penalties.
- The next $30,000 that is from taxable traditional IRA conversions will not be subject to income tax, but will be subject to the 10% penalty. This is because she paid tax on the conversion.
- The next $5000 of non-taxable Roth conversions are not subject to taxes or penalties as the conversion was a non-taxable event.
- The last $2000 is from earnings will be subject to income tax and early distribution penalty of 10%. The penalties and taxes are because she is tot 59.5 and the account has not been open 5 years.
The rules around Roth accounts are not always easy to understand. Hiring a professional like Amy can go a long way. You can find her online at https://thimbleberryfinancial.com
or give her a call at 503-610-6510.