The Roth IRA is 28 years old as of 2026 (its birthday was January 1st). Yet there is still confusion about the rules applicable whenever someone withdraws money from a Roth IRA prior to turning 59 ½. This blog post attempts to correct some misconceptions on the taxation of nonqualified Roth IRA withdrawals.

Roth IRA withdrawals are becoming more important for early retirees facing the 400 percent of federal poverty level cliff which can eliminate thousands of dollars of Premium Tax Credits. Keep reading to find out how tactical Roth withdrawals in early retirement can help enhance Premium Tax Credits. 

Roth IRAs: The Basics

A Roth IRA is a tax-advantaged account that generally offers tax-free growth for invested amounts. Taxpayers receive no upfront tax deduction for putting money into a Roth IRA. If properly executed, taxpayers can withdraw money from a Roth IRA entirely tax and penalty free, and can enjoy years of tax-free growth on the amounts invested in a Roth IRA.

Roth IRA Funding

How does one move money into a Roth IRA? There are three ways.

Annual Contributions

Generally speaking, if your income is below certain limits, you can contribute up to the lesser of $7,500 or your earned income (2026 limits) to a Roth IRA. If you are aged 50 or older, the limits are the lesser of $8,600 or earned income (2026 limits). 

Conversions

Amounts can be converted from traditional retirement accounts into a Roth IRA. Any taxpayer can convert amounts from a traditional retirement account to a Roth IRA. There are no restrictions based on level of income and/or having had earned income. 

Conversions are taxable in the year of the conversion. 

There are several reasons you might want to do a Roth IRA conversion. One might be the anticipation of paying tax at a higher rate in the future. The planning concept is to “lock in” the lower tax rate in the year of the conversion rather than tomorrow’s (anticipated) higher tax rate, and to get all of the earnings on the contribution out of income taxation.

Unlimited Roth IRA conversions form the backbone of the Backdoor Roth IRA planning concept. 

Note that inherited traditional IRAs cannot be converted to Roth IRAs.

Transfers from Workplace Retirement Accounts

A third way to get money into a Roth IRA is by using workplace retirement accounts. Amounts in Roth 401(k)s and other workplace Roth accounts can be transferred into a Roth IRA. Generally, it is best to use direct “trustee-to-trustee” transfers to accomplish this. 

Further, after-tax contributions in workplace retirement plans can be directly transferred to Roth IRAs, as discussed in Notice 2014-54. 

The ability to transfer after-tax contributions into a Roth IRA has facilitated the use of the Mega Backdoor Roth IRA planning technique. 

Roth IRA Withdrawals: The Confusion

You may have heard that you cannot take money out of a Roth IRA if the account is not 5 years old without paying tax and a penalty. Not true!

There are not one, but two, five (5) year rules applicable to Roth IRAs. But neither one of them prohibit you from taking money out of a Roth IRA you have previously contributed through annual contributions. First, I will illustrate the default Roth IRA withdrawal rules, and then I will discuss the two 5 year rules. 

Quick Thought: Most of this blog post addresses situations where the taxpayer does not qualify for a qualified distribution. Generally, a taxpayer fails to qualify for a qualified distribution if he or she has not attained the age of 59 ½, and/or if he or she has not owned a Roth IRA for 5 years. The advantage of a qualified distribution is that it is automatically tax and penalty free. 

Roth IRA Withdrawals: The Layers

Here is the default order of distributions that come out of a Roth IRA. These are the rules that apply in cases where the taxpayer does not qualify for a qualified distribution. All Roth IRAs (other than inherited Roth IRAs) the taxpayer owns are aggregated for purposes of determining his or her Roth IRA layers.

First Layer: Tax-free return of Roth IRA contributions

Second Layer: Roth IRA conversions (first-in, first-out)

Third Layer: Roth IRA earnings

Each layer must come out entirely before the subsequent layer is accessed.

Here’s a brief example:

Example 1: Samantha opened her only Roth IRA in 2018. Samantha has made three prior $5,000 contributions to her Roth IRA (one for each of 2018, 2019, and 2020). She also made a $5,000 conversion from a traditional IRA to a Roth IRA in 2018. In 2021, at a time when her Roth IRA is worth $30,000 and Samantha is 50 years old, she takes a $10,000 withdrawal from her Roth IRA. All $10,000 will be a recovery of her previous contributions (leaving her with $5,000 remaining of previous contributions). Thus, the entire $10,000 distribution from the Roth IRA will be tax and penalty free.

The Roth IRA contributions come out tax and penalty free at any time for any reason! The 5 year rules have nothing to do with whether a taxpayer can recover their previous Roth IRA contributions tax and penalty free!

For those wanting to dig deeper into the tax law, please refer to this blog post and this technical slide deck discussing why the Roth IRA contributions are distributed tax and penalty free regardless of the 5 year rules. 

Note that aggregation rules always apply. In making an analysis like the one provided in Example 1, one must account for all their Roth IRAs and treat all of their Roth IRAs as a single Roth IRA to determine their own Roth IRA layers. Roth 401(k)s and inherited Roth IRAs are not included in the analysis. 

5 Year Rule for Roth IRA Earnings

The first five-year rule for Roth IRAs applies only to a withdrawal of earnings from a Roth IRA. If the account owner has not owned a Roth IRA for at least 5 years, the earnings withdrawn from the account are subject to ordinary income tax (and possibly a penalty). 

Example 2: Joe is 62 years old in 2024. He has owned a Roth IRA since 2021. In 2024, after having made $14,000 in prior annual contributions to his Roth IRA, he withdrew $17,000 from the Roth IRA. Because Joe has not owned a Roth IRA for 5 years, the withdrawal is not a qualified distribution. Joe recovers his first $14,000 tax free as a return of contributions. The next $3,000 of earnings is taxable to Joe as ordinary income (because of the first five-year rule). Because Joe is over age 59 ½, he does not owe the ten percent penalty on the distribution. If Joe had not attained the age of 59 ½, he would owe the 10 percent penalty on the $3,000 of earnings he received. 

5 Year Rule for Roth IRA Conversions

There is a five-year rule applicable to taxable money converted from a traditional retirement account to a Roth IRA (what I will colloquially refer to as the “second five-year rule”). The idea behind the second five-year rule is to protect the 10% early withdrawal penalty applicable when someone has a traditional retirement account. Here is an illustrative example.

Example 3: Milton has $100,000 in a traditional IRA, no basis in any IRA, and is age 50. If he were to withdraw $1,000 from his traditional IRA (assuming no penalty exception applies), he would owe (in addition to ordinary income tax) a $100 penalty (ten percent) on the withdrawal. 

Okay, but what if Milton first converts that money from a traditional IRA to a Roth IRA (assume Milton has no other balance in a Roth IRA)? Would that get him out of the 10 percent penalty? No, it won’t, because of the second five-year rule.

Example 4: Milton has $100,000 in a traditional IRA, no basis in any IRA, has no Roth IRAs, and is age 50. In September 2024, he converts $1,000 to a Roth IRA. In October 2024, he withdraws $1,000 from that Roth IRA. Because of the five-year rule applicable to Roth IRA conversions, Milton will still owe the $100 penalty on the withdrawal from the Roth IRA. 

Had Milton waited until 2029 or later, he would not have owed the penalty on the withdrawal of that $1,000.

The 5 Year Rule for Roth IRA Conversions and the Backdoor Roth IRA

The Backdoor Roth IRA is subject to the second five-year rule, but the penalty effect turns out to be very minor (or non-existent) if the Backdoor Roth IRA has been properly executed.  

Conversions, the second layer of the Roth IRA stack, come out first-in, first out. Further, the taxable amount (potentially subject to the 10 percent penalty upon withdrawal) of any one particular Roth IRA conversion comes out first within the conversion amount. Thus, the second layer (the conversion layer) can be composed of several mini-layers.

Here is a quick example:

Example 5: Denzel made $6,000 nondeductible traditional IRA contributions on January 1, 2019 and January 1, 2020. On February 2, 2019 and February 2, 2020, Denzel converted the entire balance of the traditional IRA ($6,010 each time) to a Roth IRA. As of December 31, 2019 and December 31, 2020, Denzel had $0 balances in all traditional IRAs, SEP IRAs, and SIMPLE IRAs.

In 2021, at a time when Denzel is 35 years old and has made no other contributions or conversions to a Roth IRA, he withdraws $3,000 from his Roth IRA. The first $10 of the withdrawal will be from the taxable amount of his 2019 Roth conversion, and thus, will be subject to the 10 percent penalty as it violates the second five-year rule (Denzel will owe $1 in penalties). The next $2,990 is attributable to the non-taxable portion of his 2019 Roth conversion, and as such, will not be subject to the 10 percent penalty. None of the $3,000 will be subject to ordinary income tax. 

Penalty Exceptions

From time to time you will hear things such as “you can withdraw only $10,000 from a Roth IRA for a first-time home purchase.” Does that mean everything else discussed above does not apply?

Fortunately, the answer is no! 

So what is the $10,000 rule getting at? It is getting at amounts withdrawn from a Roth IRA that would otherwise be subject to the penalty (and possibly income taxes — see The Super Exceptions below). 

There are several penalty exceptions applicable to taxable converted amounts and earnings that are withdrawn from a Roth IRA in a nonqualified distribution. But the penalty exception rules generally apply on top of the usual layering rules, not instead of the usual Roth IRA layering rules. 

In a discussion on social media, I used a version of the following example.

Example 6: Jane Taxpayer, age 30, has had a Roth IRA since 2017. In 2020, she withdraws $30,000 from her Roth IRA to acquire her first home, and has never used traditional IRA and/or Roth IRA money for such a purchase. She has previously made $20,000 in annual contributions to the Roth IRA. The first $20,000 of the withdrawal is a tax-free return of those contributions (see the layers above). The next $10,000 is out of earnings (see the layers above). This $10,000 is taxable to her as ordinary income. But, because of the $10,000 “qualified first-time homebuyer distribution” exception, she does not owe the 10 percent penalty on the withdrawal of those earnings.

In this case, withdrawals used to fund certain home purchases can qualify for a penalty exception (the first-time homebuyer exception is subject to a $10,000 cap). Please visit this website for a list of the possible penalty exceptions applicable to withdrawals from a traditional IRA and a Roth IRA.

The Super Exceptions

If the taxpayer is relying on the disability, age 59 ½, death, or qualified first-time home purchase penalty exceptions, the earnings also come out income tax free so long as the taxpayer has owned a Roth IRA for five years. See slide 5 of the above referenced technical slide deck. 

As applied to Jane Taxpayer in Example 6 above, if she had owned a Roth IRA since any time in 2015 or earlier, the distribution of $10,000 of earnings would not only have been penalty free, it would have also been income tax free. 

60 Day Rollovers

A taxpayer might take money out of a Roth IRA and then reconsider. Perhaps he or she wants the money to grow tax-free. Or perhaps the taxpayer dipped into earnings and the distribution is not a qualified distribution, meaning that it will likely be subject to ordinary income tax and possibly the ten percent penalty. 

He or she might be able to roll the money back into the Roth IRA. However, the tax rules allow only one 60 day rollover every 12 months. The IRS has a website here discussing some of the issues. 

Because of the one-rollover-per-year rule, I generally advise against doing 60 day rollovers unless you need to. Generally, it is best to avoid them, and then have the option available as a life raft if money somehow comes out of a Roth IRA (or other IRA) when it should not have. Note that Roth conversions are excepted from the once-every-12-months rule. Those wanting to do so could do a Roth conversion every day if they were so inclined. 

Required Minimum Distributions

There are no required minimum distributions from a Roth IRA during the owner’s lifetime. 

Early Retirement Tax Planning

Starting in 2026, the dreaded 400 percent of federal poverty level cliff is back when it comes to claiming Premium Tax Credits against ACA medical insurance premiums. The cliff can easily cost a retired married couple over $10,000 a year in early retirement. 

This greatly increases the desirability of reducing income in early retirement. But early retirees still need to live.

Wouldn’t it be great if there was a source of funds for living expenses that is entirely tax free? Roth IRAs can be that source! 

The Roth IRA withdrawal ordering rules are so favorable that it is likely many early retirees can access thousands of dollars from their Roth IRA to fund their retirement and keep income very low. 

For those retirees younger than age 59 ½, their Roth basis (in a general sense, the combination of their historic annual contributions and their taxable Roth conversions that at least 5 years old less any previous withdrawals) can be withdrawn tax and penalty free to fund living expenses in a manner that does not increase income for Premium Tax Credit determinations. 

For those retirees who are both 59 ½ and have held any Roth IRA for at least 5 years, the only thing they can take from a Roth IRA is a qualified distribution which is always entirely tax free. 

Many retirees on ACA medical insurance plans will want to consider tactically taking Roth IRA withdrawals to limit their modified adjusted gross income (MAGI) and increase their Premium Tax Credit. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.