08 Jul How can you separate a Roth IRA’s principle and gain?

Q. Am I correct that if you convert to a Roth IRA, you can withdraw the amount converted at any time with no tax and the gain would be taxed if it is not in the account for five years? If this is correct, how do you distinguish when a withdrawal is made between principal or gain?
— Calculating

A. Yours is a great question.

Yes, you are correct that under current tax laws, you can withdraw funds tax-free from a Roth IRA after a conversion — with certain exceptions.

“If the funds are distributed within a five-year period starting with the first day of the tax year of the conversion, you may have to pay the 10% penalty tax on early distributions,” said Kelly Henning, a certified financial planner with Modera Wealth Management in Westwood.

She said the penalty tax pertains to an amount converted that you had previously included in income, as well as any earnings on the contributions.

The exceptions to this 10% penalty tax rule include the following:
· You have reached age 59½.
· You are totally and permanently disabled.
· You are the beneficiary of a deceased IRA owner.
· You use the distribution to buy, build, or rebuild a first home.
· The distributions are part of a series of substantially equal payments.
· You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income (defined earlier) for the year.
· You are paying medical insurance premiums during a period of unemployment.
· The distributions aren’t more than your qualified higher education expenses.
· The distribution is due to an IRS levy of the qualified plan.
· The distribution is a qualified reservist distribution.

Henning said if you have determined that your withdrawal from your Roth IRA could be taxable, the calculation of the tax is complicated.

She recommends you speak with a tax preparer about the nuances of this calculation, but she offered this abbreviated version of the calculation:

First, you will need to order the distribution accordingly:
1) Regular contributions
2) Conversion and rollover contributions on first-in, first-out basis: taxable amount (previously counted as income) first, then any non-taxable portion
3) Earnings on contributions

Once it is determined how the distribution fits into these categories, you will need to complete the Form 8606. Section III of the form determines the taxable amount of the Roth IRA distribution, she said.

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This story was originally published on July 9, 2021.

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