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Talking Money with Julie Stav
Retirement Accounts & Taxes

Julie,
I converted a Traditional IRA into
a Roth IRA a few years ago. Since then, I have made yearly contributions into this account. How do I figure out the taxes due if I need to access the money prior to retirement age?
—Thanks, Consuelo

Dear Consuelo,
You have posed a very interesting question. There is still a great deal of confusion among investors between these two types of IRAs. Let’s rewind a little and examine each IRA before we marry them, shall we?
In its most rudimentary terms, a Traditional IRA is a retirement account meant to be used on or after your 59 1/2 birthday. The main advantage of this IRA, if you meet the conditions specified by the IRS, is your ability to deduct the amount you deposit into this account from your taxable income. This results in a lower tax bill because Uncle Sam does not tax the money that was used to fund your IRA.
As the money in this retirement account grows, you don’t pay income taxes on its gains. After retirement age, you will pay taxes on 100 percent of the amount you withdraw from your account. That’s what is meant by the term tax-deferred. If you use the money before 59 1/2, you will pay taxes and face a 10 percent penalty from the IRS.
A Roth IRA is also a retirement account, but unlike the traditional IRA, you do not get to deduct your deposits from your taxable income. That means that your Roth IRA is funded with after-tax dollars. If you have had a Roth IRA account for five years or longer, and you withdraw the money after 59 1/2, you will not have to pay taxes on deposits or on the gains. This makes it a tax-free account.
If you tap into a Roth IRA account before retirement age, you will not pay taxes on your deposits, but your gains will be treated the same way as a traditional IRA with taxes, penalties, and the works.
Since you have a combination of these two accounts rolled up into one, here is the pecking order from the tax point of view:
Annual after-tax contributions are the first to come out. This layer of money can always be taken out tax-free at any time, since you already paid taxes on it before making your deposits.
Converted traditional IRA money comes next. You will owe a 10 percent penalty on this portion of your account if you cash it out within five years of the conversion date unless you are 59 1/2 years old, or older. If you wait the five-year period after converting your traditional into a Roth IRA, you do not have to face this penalty.
To sum up, if you wait at least five years before withdrawing any funds from conversion contributions, you won’t have to worry about any adverse tax consequences. After all contributions are withdrawn, you are dipping into Roth account earnings. This money comes out tax-free as long as the account has been open more than five years and you are at least age 59 1/2, or disabled. If you don’t meet these conditions, you will have to pay income taxes and, in most cases, the 10 percent premature withdrawal penalty.any adverse tax consequences. After all contributions are withdrawn, you are dipping into Roth account earnings. This money comes out tax-free as long as the account has been open more than five years and you are at least age 59 1/2, or disabled. If you don’t meet these conditions, you will have to pay income taxes and, in most cases, the 10 percent premature withdrawal penalty.

 

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