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February 26, 2009

Roth IRA Distributions- Determining Tax and Penalty

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by Denise Appleby, CISP, CRC, CRPS, CRSP, APA

Earnings in Roth IRAs accumulate on a tax-deferred basis, but eventually become tax-free if distributions are qualified. The determination of whether a Roth IRA distribution is qualified is fairly simple. On the other hand, determining whether any portion of a non-qualified Roth distribution is taxable is a more involved process.  The following guidelines can be used to help determine whether a Roth IRA distribution is qualified, and if it’s not qualified, the possible tax consequences that may apply.
Roth IRA Distributions
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 his/her first Roth IRA and
2.It occurs under one of the following circumstances:
oAfter the owner reaches 59 ½,
oThe 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,
oThe distribution occurs after the owner is disabled or
oThe distribution was made by beneficiaries after the owner’s death.
A distribution that meets these two requirements is tax and penalty free.
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: These are always tax and penalty free
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 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 Therefore, if the owner converted amounts in different years, the earlier conversions are withdrawn first. For instance, if an individual converted amounts in 2007 and 2008, the 2007 conversions are withdrawn before the 2008 conversions. Further, for each conversion amount, any taxable portion is withdrawn before non-taxable amounts.
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:
oUnreimbursed medical expenses that are more than 7.5% of the owner’s adjusted gross income
oThe distributions are not more than the cost of the owner’s medical insurance
oThe distributions occurred while the owner is disabled
oThe distribution was made from an inherited IRA
oThe distribution is part of a substantially equal periodic payment (SEPP)
oThe distributions are not more than the qualified higher education expenses of an eligible party
oThe distribution was used to buy, build, or rebuild a first home for the Roth IRA owner or a qualifying family member
oThe distribution is due to an IRS levy of the IRA
oThe 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
oThe distribution was eligible for rollover and is rolled over within the 60-day period
oFor 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.
Conclusion
The tax benefits of saving in a Roth IRA instead of a Traditional IRA are realized only if distributions are tax and penalty free. In order to ensure this occurs, the source of funding and determination of the five-year period for qualified distributions must be accurately tracked. Most importantly, the compound effect of tax-free savings can be quite significant. As such, individuals should defer from making withdrawals until retirement, even in cases where the distribution would be qualified.

Written By

Denise Appleby

Denise is CEO of Appleby Retirement Consulting Inc., a firm that provides IRA resources for financial/ tax/legal professionals. She has over 20 years of experience in the retirement plans field, which includes training and technical consultation.

Denise writes and publishes educational /marketing tools for advisors; available at http://irapublications.com. Denise co-authored several books on IRAs

Denise is a graduate of The John Marshall Law School, where she obtained a Masters of Jurisprudence in Employee Benefits, and has earned 5 professional retirement designations.
She has appeared on numerous media programs, sharing her insights on retirement tax laws.

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