Ordering Rules

What are Roth IRA Ordering Rules?

When it comes time to taking a Roth IRA withdrawal, the IRS has established ordering rules which guide the order of distributing funds within your Roth IRA, for the purposes of tax reporting.  These rules are put in place to order the sequence of distributions from various funding sources within your Roth IRA; such as: Roth IRA contributions, Roth IRA conversions, rollover IRA amounts, and earnings as well.  At retirement, you may have $200,000 in your accounts; however, this amount may consist of a variety of different funding sources, each of which may carry different tax consequences when withdrawn.

The IRS ordering rules apply to your Roth IRA accounts in aggregate.  For example, if you have three Roth accounts at three different financial institutions, you will need to add up the various buckets across the three accounts, which we discuss below.  Using our example from above, if you have $200,000 across 3 different accounts, you will need to split them out into buckets as we have detailed below.  IRA 1 may have $20,000 in contributions, while IRA two and three may only have $10,000 each.  Using this simple scenario, the first $40,000 that you withdraw from all of your Roth IRAs (in aggregate) will be considered tax and penalty free.  Remember, this is only for classification purposes on your tax return.  

While we are not able to select the source of funds which we want to distribute, the IRS ordering rules are designed to work to your advantage.  Let’s review the Roth IRA ordering rules in more detail.

• Any amounts related to a Roth IRA contribution will be withdrawn first from the account.  Say you contributed $40,000 into a Roth IRA over the last 10 years and you plan on distributing $2,000 a month to support your retirement; you will be able to withdraw tax free and penalty free, for 25 months.
   
• After your contributions have been withdrawn, conversions and rollover amounts will come out next.  This is done using a FIFO (first in first out) system, where the first conversion (or rollover) will come out first. 
   
• In some cases, you may be converting a traditional IRA which has both deductible and non-deductible contributions.  According to the Roth IRA ordering rules, the taxable contributions will come out first.

  In the scenario where you perform a Roth IRA conversion at the end of the one year and contribute those funds into a Roth IRA in the following year (before the tax deadline), the Roth IRA ordering rules positions this conversion before any rollovers or conversions which are performed in the following year.
   

• The remaining amount represents the earnings in the account and these come out last.  Keep in mind that earnings withdrawn in relation to an excess contribution which was made to a Roth IRA is excluded for the purposes of these ordering rules.

The benefits provided through the ordering rules can be quite beneficial to the investor, even if they perform a distribution prior to it being qualified.  The fact that they can withdraw contributions first may actually buy some time to qualify other amounts for tax free and penalty free distributions.  For example, if you do not meet the 5 year holding period or if you are not of the age of 59.5 for another year, you can still withdraw money without paying the piper.