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Roth IRA Ordering Rules

Roth IRA Ordering Rules

Traditional IRA contributions are to remain in a retirement account until the account holder reaches the specified age which is normally 59 1/2 at which point they must begin withdrawing funds with minimum annual distributions. With Roth IRA contributions however, some funds may be withdrawn early and not subject to penalty as outlined in the IRS set of ordering rules.

The ordering rule hierarchy of a Roth IRA specifies that when funds are withdrawn from the account they are considered contributions. If the total amount withdrawn is in excess of the amount that was initially contributed then the excess is designated as having been rolled over into the account. Any amount exceeding initial contributions and roll over funds are considered earnings when withdrawn from a Roth IRA.

Because the structure of a Roth IRA the account holder does not benefit financially by claiming a tax deduction which is customary in a Traditional IRA. Since there is no initial tax benefit for a Roth IRA, when funds are withdrawn at age 59 1/2, and a Roth IRA account has been in existence for at least five years, then distributions are tax free. Roth IRA contributions can be up to $5,000 per year, $6,000 if older than 50, and withdrawn at any time.

While contributed funds can be withdrawn at any time without penalty, funds rolled over to a Roth IRA from a Traditional IRA or 401(k) plan are subject to certain IRS restrictions. Due to the fact that funds being rolled over had a tax benefit the IRS requires those funds to remain in the account for a minimum of five years. For example, if a $4,000 contribution was made and then a $6000 rollover to place then if $8000 was withdrawn then $4,000 would be the initial contribution and $4,000 would be part of the rollover.

Individual Retirement Arrangements however tend to increase in value over time if the account has seen significant investment returns. Following the above example, if $20,000 was withdrawn and the roll over funds of $6,000 had been in there 10 years then $4,000 would be the initial contribution, $6,000 would be the roll over amount of greater than five years and $10,000 would be treated on taxes as earnings. Because these are earnings from a retirement account prior to the age of 59 1/2 they may be subject to a 10% penalty.

Roth IRAs do have three exceptions allowing for early withdrawals as defined by the IRS. Funds having excess contributions may be withdrawn from a Roth IRA is the account holder is disabled, the funds are to be used for the purchase or rebuilding of a first home of which up to $10,000 can be used and any beneficiary who inherits a Roth IRA can obtain the full distribution without the customary 10% penalty. However, the beneficiary of funds received from a Roth IRA may be treated as earned income on taxes at the individual's tax rate.

Roth IRAs have become a popular retirement account and investment vehicle for many individuals. As with all investments however, it is important to completely understand the guidelines as established by the IRS and the possible penalties which could be incurred if funds are withdrawn early. A little knowledge goes a long way and understanding Roth IRA ordering rules can prevent headaches if funds are withdrawn early by minimizing expenses and penalties.