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Tutorial: Roth IRA Distributions

 

Distributions from Roth IRAs are tax and penalty-free, if the distribution is qualified. For non-qualified distributions, the ordering rules must be used to determine if tax and/or the early distribution penalty applies to the distribution amount.
 Qualified Distributions Defined
A qualified Roth IRA distribution is one that meets the following two requirements:
1.         It occurs at least five years after the owner established and funded her first Roth IRA and
2.         It occurs under one of the following circumstances:
o   After the Roth IRA owner reaches age 59 ½,
o   The distribution was used towards the purchase, building or rebuilding the first home for an eligible party. This is subject to a life-time limit of $10,000,
o   The distribution occurs after the owner is disabled or
o   The distribution was made by the Roth IRA owner’s beneficiaries after the owner’s death.
A distribution that meets these two requirements is tax free and is not subject to the early distribution penalty.
Non-Qualified Distributions
 
For distributions that are non-qualified, the ordering rules must be used to determine whether the amount is subject to income tax and/or the 10% early distribution penalty.
According to these ordering rules, distributions from Roth IRAs occur in the following order:
1.         Regular Roth IRA contributions: Distribution of these amounts are always tax and penalty free , and can be taken at anytime- regardless of the length of period for which they were held in the Roth IRA.
2.         Roth conversion amounts: These are distributed only after all regular contributions have been distributed from the Roth IRA. These are subject to a 10% early distribution penalty, if it has been less than five years since the amount was converted, unless an exception applies. However, no income tax applies, as these amounts would have already been taxed at the time of conversion. Each conversion is subject to its own five year holding period. Therefore, if the owner converted amounts in different years, the earlier conversions are withdrawn first. For instance, if an individual converted amounts in 2008 and 2009, the 2008 conversions are withdrawn before the 2009 conversions. Further, for each conversion amount, any taxable portion is withdrawn before non-taxable amounts.
Example 1:
Jane converted $50,000 to her Roth IRA in 2004. In 2008, she converted an additional $40,000
Jane takes a distribution of $20,000 from her Roth IRA in 2009. The distribution is free from federal tax, because the tax was paid when she filed her 2004 tax return. It is also penalty-free because it is considered distributed from the $50,000 under the ordering rules, and the $50,000 has aged for at least five years.
3.         Earnings: These amounts are distributed only after all regular contributions and conversion amounts have been distributed. These amounts are subject to income tax. They are also subject to the 10% early distribution penalty, unless an exception applies  
 
The exceptions to the 10% early distribution penalty applies to amounts used for (or as a result of ) the following:
o   Unreimbursed medical expenses that are more than 7.5% of the owner’s adjusted gross income
o   The distributions are not more than the cost of the owner’s medical insurance
o   The distributions occurred while the owner is disabled
o   The distribution was made from an inherited IRA
o   The distribution is part of a substantially equal periodic payment (SEPP)
o   The distributions are not more than the qualified higher education expenses of an eligible party
o   The distribution was used to buy, build, or rebuild a first home for the Roth IRA owner or a qualifying family member
o   The distribution is due to an IRS levy of the IRA
o   The distribution represents any nontaxable amount from the IRA. Nontaxable amounts would be from any non-deductible contributions or rollover of after-tax amounts that was converted to the Roth IRA, or from regular contributions made to the Roth IRA
o   The distribution was eligible for rollover and is rolled over within the 60-day period
o   For purposes of determining whether a Roth IRA distribution is qualified, all of an individual’s ‘own’ Roth IRAs are treated as one Roth IRA. That is, this does not include inherited Roth IRAs.
 
RMD Rules
Unlike traditional IRAs, the required minimum distribution (RMD) rules do not apply to Roth IRA owners. They do however, apply to Roth IRA beneficiaries. Beneficiaries may distribute inherited Roth IRA assets under one of the following options:
1.      The five year rule, where the assets are distributed by the end of the 5th year following the year the Roth IRA owner died, or
2.      Over the beneficiary’s single life expectancy.
Failure to withdraw RMD amounts by the applicable deadline will result in the beneficiary owing the IRS an excess accumulation penalty of 50% of the shortfall.
 

 

                    I.            Tutorial: Roth IRA Contributions
                  II.            Tutorial: Excess Roth IRA Contributions
                III.            Tutorial: Roth IRA Conversions
               IV.            Tutorial: Roth IRA Reconversions
                 V.            Tutorial: Roth IRA Rollovers and Transfers