We constantly see questions regarding the distribution rules for Roth IRAs. Personally, I’ve always thought that the failure to understand these rules prevents many from truly appreciating the benefits of these accounts. Traditional IRAs are easy. Unless we are talking about nondeductible contributions, the money is deductible when contributed and taxable upon withdrawal. There’s also the early distribution penalty that could apply depending on the circumstances.
Roth IRAs have a couple of different rules, including two separate 5-year rules. The easiest way to understand these rules is to remember that a Roth IRA consists of two parts: (1) contributions/conversions and (2) investment gains/losses. This is important because contributions can always be withdrawn at any time, tax and penalty free. The earnings, however, are potentially taxable and could be hit with the early distribution penalty.