A Roth IRA is nice in that withdrawals are tax-free*. In the simplest case, you just throw money into it, and when you take the money out, it’s tax-free.
The asterisk on “tax-free” says it’s not always tax-free. You get the simplest case if you wait until you are 59-1/2 for all your withdrawals (you also must have opened your first Roth IRA at least five years before then). It’s more complicated if you take money out before you are 59-1/2.
Some say a Roth IRA can be used as an emergency fund because you can withdraw the “principal” of your contributions at any time, tax-free, no questions asked. It’s true. However, if you ask me now how much “principal” I currently have available in my Roth IRA for this type of withdrawal, I have no idea. Do you know yours?
I haven’t tracked how much “principal” I contributed to my Roth IRA over all these years. Even though I kept all my tax returns, only conversions to Roth were on the tax returns. Direct contributions weren’t. My Roth IRA also moved a few times. My current Roth IRA custodian doesn’t know whether or how much I contributed to my Roth IRA in 2001.
This calls for the need to create and maintain a spreadsheet for your Roth IRA contributions and withdrawals. You record only the in’s and out’s — what happens inside the Roth IRA or between two different Roth IRAs doesn’t matter. The spreadsheet should have these columns:
- Tax Year
- Transaction Type:
- conversion, the taxable portion
- conversion, the non-taxable portion
- distribution (withdrawal)
- Available For Withdrawal
For this purpose, you treat all your Roth IRAs as one large Roth IRA (but your Roth IRA and your spouse’s Roth IRA are separate). If a conversion is partially taxable, you do two entries, one for the taxable portion, and another for the non-taxable portion. The “Available For Withdrawal” column is initially the same as the Amount column. You then update it as you take withdrawals. You have to do that because withdrawals from a Roth IRA must follow a specific order:
- First your contributions so far
- Then the taxable portion of the first conversion
- Then the non-taxable portion of the first conversion
- Then the taxable portion of the second conversion
- Then the non-taxable portion of the second conversion
- … …
If you are married, you have to have two separate sheets, one for each person.
Depending on the type of money and the timing, the tax treatment on the withdrawal is different. Sometimes it’s tax-free penalty-free. Sometimes you pay a 10% penalty but no tax. Sometimes you pay tax but no penalty. Sometimes you pay both tax and penalty. If you do multiple withdrawals before 59-1/2, it will be very difficult to tell what type of money you are withdrawing and what types are left in your Roth IRA unless you maintain a spreadsheet like this.
Here’s a math exercise:
You were 30 when you first contributed $2,000 to your Roth IRA. You contributed $2,500 in the second year, and you converted $5,000 to Roth, all of which was taxable. In the third year you didn’t contribute but you withdrew $3,000. In the fourth year you contributed $3,000 and then withdrew $6,000. What’s the tax treatment on this $6,000 withdrawal?
If you throw in some rollovers or recharacterization it will be even messier.
Too complicated? I think so. I cop-out by not planning to take any withdrawal from my Roth IRA before 59-1/2. To those who will retire early, I say if someone must touch their Roth IRA before 59-1/2, they don’t have enough saved.
However, even if you don’t plan on it, you never know what will come up in the future that makes it beneficial to withdraw from your Roth IRA before you are 59-1/2. You’d hate to find out you don’t have good records when you want to do it. So if you are still under 59-1/2, get that spreadsheet going now and retrace your history of Roth IRA contributions and distributions.
Here’s my spreadsheet template, filled in with sample data from the math exercise above.
The 5498 forms you received from your IRA custodian(s) will help you reconstruct the history. Did you save those? I didn’t save them in the early years. Now I have some homework to do too.
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