Tax Treatment of Roth IRA Distributions

(January 30th, 2008)

The Roth IRA was created by the Taxpayer Relief Act of 1997, pioneered by the late Senator William V. Roth, Jr. and was made effective on January 1st, 1998. Before 1998, investors who wanted to contribute towards an IRA would either make a deductible or non-deductible contribution to a Traditional IRA. Distributions taken from a traditional IRA were taxed as normal income, and early withdrawals before the age of 59 and a 1/2 were subject to a 10% early withdrawal penalty. The Roth IRA allows investors to take tax-free qualified distributions from their Roth IRAs without having to pay the 10% penalty. Here's how it works.

Qualified Roth IRA Distributions?

Non-qualified Roth IRA distributions will be subject to normal income tax and a 10% early withdrawal penalty. A qualified distribution on the other hand must meet these criteria:

i) The distribution occurs at least 5 years after the investor established and funded his Roth IRA account. For this purpose, the five year period begins with the first day of the year for which the first contribution was made. For example, if the contribution was made on April 14th, 200, the 5 year period begins January 1st, 2000.

ii) The distribution must be taken under one of the following circumstances:

- the Roth IRA investor must be 59 and 1/2 years or older at the time of the distribution
- the Roth IRA investor becomes disabled at the time of taking the distributions
- the Roth IRA investor dies and his/her beneficiary receives the assets contained in the plan
- the distributions taken from the Roth IRA will be used in the purchase or building of a new home for the Roth IRA holder or qualified family member. This is limited to $10,000 per person per lifetime. Qualified family members include:
- the Roth IRA investor
- the Roth IRA investor's spouse
- children of the Roth IRA investor
- grandchildren of the Roth IRA investor
- parent or ancestor of the Roth IRA investor

Taxing the Non Qualified Roth IRA Distributions

How non-qualified Roth IRA distributions are taxed depends on the source of the Roth IRA's assets. There are 4 possible sources of Roth IRA assets:

- Normal contributions by the investor
- Earnings received on all contributions made by the Roth IRA investor
- Roth conversion of taxable traditional IRA assets
- Roth conversion of nontaxable traditional IRA assets

The IRS uses the source of the Roth IRA's assets to determine 'ordering rules' of how assets will be distributed from the Roth IRA account. They are distributed in the following order:

1. Normal Roth IRA contributions by the holder
2. Taxable traditional IRA conversions
3. Non-taxable traditional IRA conversions
4. Capital gains and earnings made on all Roth IRA assets

Important Fine Print

i) Distributions of Roth IRA assets from normal participant contributions and from non-taxable conversions of traditional IRA assets can be taken anytime, tax free, if the 2 above criteria are met.

ii) Non qualified distributions of taxable traditional IRA conversion assets are subject to 10% early withdrawal penalties.

iii) Non qualified distribution of capital gains & earnings on normal contributions may be subject to income tax and 10% penalty.

Illustration

Simon established his first Roth IRA in 2002 and made annual participant contributions of $2000. In 2006, he converted his Traditional IRA assets to his Roth IRA for $40,000 (which was established in 2002). In 2007, Simon turns 55 years of age and wants to make some distributions of his assets. Here is his Roth IRA asset account at this time.

Assets Source

Simon wants to know the tax consequences if he distributes assets from his Roth IRA. Remember that assets are distributed in the following order; i) normal participant contributions ii) traditional IRA conversions iii) earnings.

i) Distribution of $10,000

A distribution of $10,000 is tax and penalty free because it comes from normal participant contributions made by John. Normal participant contributions have no waiting period for distributions and are tax free according to the IRS.

ii) Distribution of $25,000

The first $10,000 out of the $25,000 is tax and penalty free because it comes from normal participant contributions made by John (in Case i). The other $15,000 comes from taxable traditional IRA conversions made in 2006. Because these conversion assets were taxed when converted, they are not subject to tax now. However, they will be subject to the 10% early withdrawal penalty fee unless 5 years have passed since the conversion was made. The penalty can still be waived if any of these criteria is met:

i) Simon is 59 and 1/2 years of age or older (Simon is 55 at this time so this does not apply)
ii) Simon plans to use the distributed funds to purchase or build a new home for himself or his children, grand parents, spouse. There is a limit of $10,000 that can be distributed tax free.
iii) Simon becomes disabled before the distribution occurs
iv) Simon dies and his beneficiary takes over the assets
v) Simon uses the funds for medical expenses that are not reimbursable
vi) Simon uses the funds for higher education, college and university tuition fees
vii) Simon pays for medical insurance after an unfortunate job loss
viii) Simon's assets are distributed as part of an IRS levy

iii) Distribution of $60,000

The first $10,000 withdrawn is penalty and tax free as in Cases i and ii. The other $40,000 is not subject to tax because the conversion assets were already taxed when the conversion occured, as in Case ii. The remaining $10,000 is attributed to non-taxable conversion assets and is not taxable because no deductions were allowed when assets were contributed to the Traditional IRA.

iv) Distribution of $65,000

Up to $60,000 of the funds will be treated as explained in Cases i to iii. The remaining $5000 is not subject to tax because Simon has had his Roth IRA for 5+ years and if he meets one of the following criteria:

i) Simon is 59 and 1/2 years of age or older (Simon is 55 at this time so this does not apply)
ii) Simon plans to use the distributed funds to purchase or build a new home for himself or his children, grand parents, spouse. There is a limit of $10,000 that can be distributed tax free.
iii) Simon becomes disabled before the distribution occurs
iv) Simon dies and his beneficiary takes over the assets

If none of these 4 rules apply to Simon, then his $5000 will be subject to income taxes as well as the 10% early distribution penalty.

Conclusive Points

- If an IRA holder does multiple Roth conversions, the 5 year period for each conversion is determined separately.
- If excess contributions are made to a Roth IRA and later withdrawn, these contributions cannot be included as part of 'normal participant contributions' for qualified distributions
- Roth IRA holders should keep a record of all their transactions and file the appropriate documents with the IRS for each of their transactions.