How to Withdraw your Roth IRA Basis Tax Free with No Penalty
First off, I want to say thank you for being a valuable reader thus far and for following my content. This blog post marks the first article in our tax unit that we are writing on this blog. I plan to turn this website into a Tax Professional, Retirement Planning and Joint CFP/CPA style blog. I will remain anonymous for the purpose of writing this blog but I am a CFP and aspiring CPA. I also have an Accounting degree, years of work experience in tax and over 7 years total experience in Financial services. In this article, we’ll talk about how to withdraw your Roth IRA basis tax free with no penalty. It’s an issue that is passionate to me because I see people RARELY if ever tracking their basis on their Roth IRAs, and on their 529s, Roth 401Ks, After Tax 401Ks, NONDED Traditional IRAs, and the like of retirement accounts.
Basis tracking and putting clean Excel documents together, alongside meticulous record keeping of your 5498s and statements can absolutely save you from massive tax penalties should you need to make a Roth IRA early withdrawal. And since some simple to intermediate accounting can actually save you money in this instance, I thought it prudent to write a full article. Feel free to comment down below with any questions you may have.
Introduction: Why Roth IRA Withdrawals Are Misunderstood
Roth IRA’s are mainly thought of as the retirement investing vehicle in which individual’s can accumulate investment growth, and then pull out all the gains and contributions 100% tax free over the age of 59 1/2. The typical rule is below:
- Be over age 59 1/2 at the time of withdraw – incur no penalty and pay no taxes on withdrawal. As long as….
- Also have had the account open for at least five years – It is fine to move vendors, say from Fidelity to charles Schwab, as long as your beginning chain of having the account opened is five years from day 1.
So those are the simple tax rules on the Roth IRA. If such a thing exists. But then we get into retirement planning, tracking your basis (basis = your contribution amount. If you put $4000 in in 2023, it grew to $8000 by 2026. Your “basis” in your Roth IRA is your $4000 contribution), tracking your Roth Conversion amounts, Mega Backdoor Roth Conversions, Pro Rata rules on conversions, regular Roth Conversions vs backdoor roth conversions, even 529 to Roth IRA Conversions.
The list goes on and on, and after awhile the rules get ridiculous! To the point that you’d need to almost BE a CPA yourself, or at least retain one in order to have a shot at getting all of this right. If you’re a tax professional and you’re reading this article right now, this is the reason why they teach you the ACCOUNTING and the TAX mechanics on the CPA exam and in public accounting. Because the Accounting provides the numbers, the backing and the documentation, and the tax knowledge gets it filed correctly. See how to document and withdraw basis below.
Roth IRA Basics: Contributions vs. Earnings
On a Roth IRA (as well as any other non tax deferred retirement account. Anything else after tax where you’re making a contribution with money that you’ve already paid taxes on) you have two components. Contributions and Earnings.
- Contributions – Contributions are how much you’ve actually put into your Roth IRA thus far. Your actual money, that you paid tax on, that you decided “I’m contributing this to my Roth IRA this year.” This is what I’ve been referring to as your “basis” throughout this article. Your basis (almost like your cost basis) in your IRA. Best ways to track this, in a nutshell, are through a dedicated Excel sheet that you monitor year over year, Form 5498s that you pull in May each year and keep them in a folder, as well as Statements for the month in question where you made a contribution. #1 on this list is absolutely FORM 5498. IRS will have a record of this alongside you, and therefore they can verify that you actually DID contribute what you say you did. It is up to you to report it correctly also using your 1099-R. Reminder: you can pull your contributions with no tax penalty or tax bill, if reported and logged correctly, regardless of age or how long the contributions have been in the account. You’ve already PAID your taxes on this money so the IRS has no reason to penalize you for it.
- Earnings – Earnings are taxed in a very different way. To get the full tax break on these you’ll need to be over 59 and 1/2, and have held the Roth IRA account open for a minimum of five years (you can move brokers etc. but in succession the account must be and stay open for five years.) If you withdraw these before meeting BOTH of these tests. You’ll pay an immediate penalty of 10% on the earnings AS WELL AS ordinary income taxes. Yes that’s right, since you didn’t pay taxes on that money yet, if you don’t wait until retirement age and get your Roth IRA tax free super power, you pay tax on all the earnings and can only pull your contributions with no penalty.
That’s the gist of Roth Contributions vs earnings. My simple advice to you, would be to track your Roth Contributions, your Nondeductible Traditional IRA contributions, and your After Tax 401K and Roth 401K contributions. Anything that you’ve already paid taxes on. Track it, track it, track it. It will save you if the IRS ever comes back for documentation proving that you should indeed not be taxed on a certain early withdrawal.
What Counts as “Tax-Free and Penalty-Free”
First you have the Roth IRA ordering rules. Which is
- Contributions first
- Then any conversions that you’ve done that have a five year rule attached to them. Like if you did a Roth IRA Conversion or Roth 401K Rollover (which works as a conversion effectively)
- And finally earnings which will have a 10% penalty and ordinary income taxes attached to them unless you’re over 59 and 1/2 and have held the account for more than 5 years.
There you have it. The above is how you withdraw from your Roth IRA tax free. I will say that rigorous tracking and documentation as well as proper tax filing is required in order to do this correctly in the case you actually need capital from your Roth IRA and don’t want to pay taxes on it. It is quite time consuming to document all of this, so I would recommend having an Excel sheet on hand documenting everything, as well as all of your 5498s. I am learning that tracking your assets and really doing so in a manner like a CPA would is practically akin to running your own business. It takes an incredible amount of time to review everything, document everything, come up with realistic numbers. etc. etc. It is a good feeling, but nonetheless, I would compare it to running a business in terms of how much time it is going to take to really do this over the long run.
To get the basics however: Simply pull all 5498s and keep an Excel sheet and keep in a folder – And its done. At least for your Roth IRA.
When Taxes and Penalties Actually Apply
In the event that a taxpayer fails to document all of the above, and either ends up getting a letter that the IRS is looking at their tax return or just plain is taking earnings from the Roth IRA, the penalties are pretty steep.
- Penalty for withdrawing earnings early – The penalty for early withdrawal of earnings is income taxes at ordinary rate + a 10% penalty on all earnings. This would happen if either you didn’t have proper documentation to show basis, or if you had already depleted everything in terms of your contribution and you were now pulling from earnings. There are also certain forms that need to be file with your actual tax returns that will cause a penalty if not reported correctly.
- Correctly reporting on your income taxes that your Roth IRA withdrawal is a return of basis – You will need to file IRS form 8606 in order to report this. It doesn’t track basis on like a revolving schedule, but rather is something you file as needed to prove out basis and the withdrawal of funds thereafter. You have to file this to prevent a match notice from the IRS, the computers might flag that there was a non penalty withdrawal otherwise. Review your 1099R especially things like Box 1a. which will go over total gross distribution amount, and the other boxes which will indicate distribution codes lacking information that you’ll need to add to your tax return.
Accounting for Your Roth IRA: Why Record-Keeping Matters
From the above, you can see that accurate Accounting for your Roth IRA is a valuable skill, and can give you liquidity on a lot of different “retirement account” types if you ever need to pull money from them. Whether it is a:
A. 401K
B. Roth IRA
C. Roth 401K
D. Traditional IRA
E. 529 and 529 Basis Tracking for Return of Capital
F. Health Savings Account
And all of the tax code benefits and exclusions of each account type. There is absolutely a way to pull funds from all of them without much damage in terms of a tax bill. Keeping receipts, keeping excel sheets, keeping good accounting records as you go along, and everything in between is the key to doing so. If you have to go back in time and try to recreate them it is very painful, inaccurate, time consuming and expensive to try and do so .
Conclusion: The Roth IRA Advantage Done Right
Thanks for reading. I’ll be blogging more about upcoming Tax advantaged accounts, finance, CFP, CPA content, and related topics. I really enjoy giving back in terms of financial literacy and explaining how different retirement accounts or tax code sections work. And it is a big help to me as I pursue my CPA license. Until then thanks for reading and I’ll see you on the next post!
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