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Financial Planning Question: After Tax Contributions

Q: In the book “You Can Retire Sooner Than You Think” there is a section on Roth IRAs that says, “Contributions are made with after-tax dollars and can be withdrawn at any time without penalty.” Recently, I visited a Financial Advisor who told me there is a 10% penalty even for contributions. Can you tell me who is correct?

A: Distributions from Roth IRAs are designed to be tax-free in retirement. A distribution from a Roth IRA is not included in the owner’s gross income and is not subject to the 10 percent early withdrawal penalty if it is a “qualified distribution.”  Distributions that do not meet the definition of a qualified distribution may be subject to income tax and the early withdrawal penalty.

 

Qualified Distributions – are distributions from a Roth IRA that satisfies both the following tests:

1. The distribution must be made after a five-taxable year period, and

2. The distribution satisfies one of the following four requirements:

a.      Made on or after the date on which the owner attains the age of 59½

b.      Made to the beneficiary or estate of the owner on or after the date of the owner’s death

c.      Is attributable to the owner being disabled, or

d.      For first time home purchase (lifetime cap of $10,000 for first time homebuyers)

 

Nonqualified Distributions – Any amount distributed from an individual’s Roth IRA that is not a qualified distribution is treated as made in the following order

·         From regular contributions

·         From conversion contributions on a first-in-first-out basis, and then

·         From earnings

In the event a distribution is not a qualified distribution, the first layer will be return of adjusted basis (from after-tax contributions), followed by post-tax conversion contributions.  Since these contributions have already been taxed there will be no income tax consequences (although there may be a penalty). The final layer consists of tax-deferred earnings on contributions and conversions within the Roth IRA, which will be subject to tax and penalty if the distribution is not a qualified distribution.

Distributions will generally not be taxable to the extent that total distributions do not exceed total contributions and conversions.


 

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