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Restore order to Roth IRA withdrawals

by on
in Small Business Tax,Small Business Tax Deduction Strategies

If you need cash in a hurry and can’t afford to pay much tax, you may have more options than you think.

Strategy: Consider a withdrawal from a Roth IRA. Despite the common perception, nonqualified distributions from a Roth aren’t fully taxable. In fact, they might not be taxable at all!

Here’s the story: Qualified Roth IRA distributions are 100% exempt from tax. For this purpose, a qualified distribution is generally one from a Roth in existence for at least five years that is made after reaching age 59½, upon death or disability or used to pay first-time homebuyer expenses (up to a lifetime limit of $10,000). All other distributions are so-called nonqualified ­distributions.

But tax is assessed on nonqualified distributions under special taxpayer-friendly “ordering rules.” How it works: Nonqualified withdrawals are treated as coming from Roth IRA balances in the following order.

1. Regular Annual Roth contributions. These amounts can be taken out tax-free in all cases.

2. Contributions from converting taxable traditional IRA balances into Roth status (i.e., “taxable conversion contributions”). These amounts can be taken out tax-free, but a 10% penalty tax generally applies to such withdrawals taken within five years of the conversion contribution, unless you’re age 59½ or older.

3. Contributions from converting nontaxable traditional IRA balances into Roth status (i.e., “nontaxable conversion contributions”). These amounts can be taken out tax-free in all cases.

4. Earnings that accumulated within the Roth IRA. These amounts are taxable. In addition, a 10% penalty tax may apply to such withdrawals taken before age 59½.

In other words, if you don’t reach the point where you’re withdrawing Roth IRA earnings, you generally will have little or no income tax to pay on nonqualified distributions.

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