How does IRS determine if an early Roth withdrawal is contributions or earnings?

[stacyknutson]

We are trying to plan for FIRE within the next couple of years, and I'm trying to figure out how we're going to most easily be able to access our retirement accounts penalty-free.

I have a 457(b) through my employer, so we will be able to withdraw from that at any time (no penalty). I have a small SIMPLE IRA from a previous employer, and my husband has one from his current employer. We are planning to do Roth conversion ladders with those. We will also have something like $140,000 in Roth contributions that we could withdraw penalty-free and tax-free.

The trouble is that we will have an additional $200,000 or so locked up in Roth IRAs that are earnings (not contributions). Twenty years ago when I set up my Roth IRA, I had no idea I'd be pursuing FIRE, and didn't have any knowledge about Roth conversion ladders or anything else that would have been useful to know in terms of preparing for FIRE. So now that we're very close, I'm trying to figure out what to do. We do have a 529 plan with about $25,000 in it for our daughter (who is 8). We have been saving about $3,000 per year in that, and had planned to continue to do so after FIRE. But now I'm wondering if we should stop those contributions since we could just withdraw from our Roth IRAs to cover qualified education expenses. There wouldn't be any penalty from what I understand. There would be income tax on any earnings we withdraw, but our tax bracket would be incredibly low at that time, so the taxes would be minimal or nonexistent.

My understanding is that Roth IRA balances don't count towards the expected family contribution, but once you take withdrawals, the FAFSA will count that as income for that year, so you should try to wait on Roth withdrawals for education purposes until the student has completed the FAFSA for the second year of college. We could aim to have the 529 cover the first couple of years of college, and use the Roth funds for subsequent years.

At the same time, we'd like to avoid using the contribution portion of our Roths for education expenses, since we would like to save those penalty-free withdrawals for our own (non-educational) needs.

So, my questions are as follows:

• When we make an early Roth IRA withdrawal, can we specify whether we want to withdraw contributions versus earnings? Or is it always assumed that you are withdrawing contributions first? Is there any way around that?
• If we start a Roth conversion ladder well before we have education expenses, will it interfere with how our withdrawals for qualified education expenses are treated (earnings versus contributions)? I feel like the answer should be pretty simple, but I'm having trouble visualizing it, so I'm not sure.
• On a slightly unrelated note, I'm feeling like we should immediately stop our Roth IRA contributions, and instead open traditional IRAs. Since we're very close to FIRE, this will mean pretty small balances for those, but it will reduce our tax bill now and open up more funds later for the Roth conversion ladder. Are there any potential issues with that that I'm not seeing?
• Do you have any other advice for our situation? Is there anything I'm missing?

[dandarc]

Answering the question in the subject line:

The IRS has ordering rules for non-qualified withdrawals from Roth IRAs that are:

1. Contributions (no tax or penalty)
2. Conversions in the order they happened
2a. Taxable portion of the conversion (penalty - you already payed tax when you converted)
2b. Non-taxable portion of the conversion (no tax or penalty)
3. Earnings (tax and penalty)

ETA: I see you're asking specifically about the qualified education expenses withdrawal. I don't personally know of any exceptions to the general case above, but I'm looking at it as I'm interested to know.

[dandarc]

I'm not seeing any exceptions to the ordering rules, but withdrawing for qualified higher education expenses does not incur the penalty. So if you got into 2a or 3 in a particular year withdrawing from the Roth IRA, you'd still owe tax but not the 10% additional tax for early withdrawal.

[terran]

Here's a table explaining what @dandarc posted that I find helpful: https://www.retirementlc.com/wp-content/uploads/2017/07/2017-07-06-Roth-IRA-Distribution-Ordering-Rules.pdf

Assuming you're paying a higher marginal tax rate now than in retirement then you should contribute to traditional now and Roth convert in retirement. Remember to consider any tax credits you get now that are income based (savers tax credit, earned income tax credit), and any planned move to a lower/higher tax state.

If you're eligible to make deductible IRA contributions that indicates you might be in a fairly low tax bracket now (not more than 12% unless you don't have a retirement plan at work), so also consider the effect of losing ACA subsidies in retirement by raising your income with Roth conversions. I haven't looked terribly closely at that, but I think it works out to something like a 10% "tax" and much more if the conversion pushes you over certain thresholds/cliffs. If you'll be in nearly the same state+federal bracket in retirement as you are now (all things considered) I would probably contribute to Roth instead because of this.

[dandarc]

• When we make an early Roth IRA withdrawal, can we specify whether we want to withdraw contributions versus earnings? Or is it always assumed that you are withdrawing contributions first? Is there any way around that?
  See ordering rules
  
• If we start a Roth conversion ladder well before we have education expenses, will it interfere with how our withdrawals for qualified education expenses are treated (earnings versus contributions)? I feel like the answer should be pretty simple, but I'm having trouble visualizing it, so I'm not sure.
  Once conversions are 5 tax years old, the conversion amount effectively moves from 2a to 2b in the ordering rules. This would give you more money in the Roth IRA sooner to withdraw tax and penalty free, as the conversions involved in the ladder are "used up" in order, first in first out.
  
• On a slightly unrelated note, I'm feeling like we should immediately stop our Roth IRA contributions, and instead open traditional IRAs. Since we're very close to FIRE, this will mean pretty small balances for those, but it will reduce our tax bill now and open up more funds later for the Roth conversion ladder. Are there any potential issues with that that I'm not seeing?
  See terran's note - if you think your marginal tax rate is going down in retirement, it is likely traditional is the better play.
• Do you have any other advice for our situation? Is there anything I'm missing?
  Keep good records. A spreadsheet tracking all those Roth IRA contributions and conversions will be a great help once the withdrawals start.
  

Answer's to your questions in bold.

[terran]

• Do you have any other advice for our situation? Is there anything I'm missing?
  Keep good records. A spreadsheet tracking all those Roth IRA contributions and conversions will be a great help once the withdrawals start.
  

Beyond a spreadsheet to help you keep track of things, the records you want are form 5498 which will show contributions and conversions, and form 1099-R which will show both the conversion amount and the taxable amount of the conversion.

[stacyknutson]

Here's a table explaining what @dandarc posted that I find helpful: https://www.retirementlc.com/wp-content/uploads/2017/07/2017-07-06-Roth-IRA-Distribution-Ordering-Rules.pdf

Assuming you're paying a higher marginal tax rate now than in retirement then you should contribute to traditional now and Roth convert in retirement. Remember to consider any tax credits you get now that are income based (savers tax credit, earned income tax credit), and any planned move to a lower/higher tax state.

If you're eligible to make deductible IRA contributions that indicates you might be in a fairly low tax bracket now (not more than 12% unless you don't have a retirement plan at work), so also consider the effect of losing ACA subsidies in retirement by raising your income with Roth conversions. I haven't looked terribly closely at that, but I think it works out to something like a 10% "tax" and much more if the conversion pushes you over certain thresholds/cliffs. If you'll be in nearly the same state+federal bracket in retirement as you are now (all things considered) I would probably contribute to Roth instead because of this.

We are just under the MAGI limit for deducting IRA contributions, and yes, we are in the 12% bracket for taxable income. Our expected retirement income (and expenses) will be under $40,000/year in retirement, including our planned Roth conversions, so based on available health care plans currently in our state (no telling what the future will hold...), we will be in a low enough income bracket that we will qualify for what's basically a public option in our state. If we went over $40,000 by more than a few thousand dollars, it would bump us up, but not enough to ruin any of our retirement plans. After the standard deduction (and personal exemptions, if those are back by then), and child tax credits, etc., we're looking at almost a 0% effective tax rate in retirement based on our current plans (unless I'm missing something).

So it definitely seems like your first scenario above (that we are in a higher tax bracket now than we will be in retirement) applies. And thank you for the link to that PDF. I hadn't seen that before, and it outlines the information in a very helpful way.