Death & Taxes

Roth IRA, Part III

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By Roy Lewis

Now we'll review the tax treatment of qualified distributions from Roth IRAs. Please, though, if you are unsure about the definitions of "conversions" and/or "contributions" to a Roth IRA, read Parts I and II of this series. You need a working knowledge of those terms before you can plan any Roth IRA distribution.

Qualified Distributions

Any qualified distribution from a Roth IRA is not included in gross income for individual tax purposes. Simple as that. A qualified distribution from a Roth IRA is tax-free -- no taxes due on the principal, no taxes due on the earnings, no taxes due period.

To be qualified, the distribution must be:
  • Made on or after the date you become age 59-1/2; or
  • Made to your beneficiary, or to your estate after you die; or
  • Made to you after you become disabled within the definition of the IRS code; or
  • Used to pay qualified first-time homebuyer expenses. (However, be sure to read my article IRA Withdrawal (Penalty-Free) for Homebuyers because, while this is a qualified distribution that can be done penalty-free, this type of distribution might not be tax-free, too.)
Feel good because you've met one of the qualified distribution rules above? Well, don't stop reading quite yet... there is one more mountain to climb. Even if you meet one of the above qualifications, the distribution is still not qualified if it is made within a five-tax-year period of the first contribution or conversion to the Roth IRA account. We'll cover this in more detail in a minute.

Conversely, many people are under the impression that, as long as the Roth IRA funds are maintained in the Roth IRA account for more than five years, any distribution after that time will be treated as tax- and penalty-free. Again, not true.

You have to meet two sets of rules before a Roth IRA distribution becomes qualified to avoid taxes on the earnings and possible penalties -- the distribution rules and the five-tax-year rule. Let's look at how a misunderstanding caught Bill by surprise.

Example #1: Bill is 25 and made a $2,000 Roth IRA contribution in 1999. In 2006 (well beyond the five-tax-year period), Bill closes his Roth IRA and takes the total of $4,500 (representing the original $2,000 contribution and $2,500 in earnings) as a distribution.

Bill is not disabled, nor does he use these funds to pay first-time homebuyer expenses. Since Bill is not over age 59-1/2 when he takes the distribution, it is not qualified. While Bill will receive his original $2,000 contribution free from tax and/or penalty, he will owe income taxes on the $2,500 of earnings. Additionally, Bill will pay a 10% "early" distribution penalty tax on the $2,500 of earnings from the account. Ouch.

Remember that, under the Roth IRA rules and unlike the rules for a regular IRA, you can first remove your contributions without tax or penalty. So, in Example #1 above, if Bill decided to take a withdrawal of only $2,000, it would be treated as a distribution of his original contributions, and would not be subject to taxes or penalties. That only makes sense, because Bill didn't get to deduct that contribution from his taxable income when it was originally made (so, he's already paid income tax on the money).

The lesson? Don't get too creative here. The IRS has ordering rules that must be followed whenever you take a distribution from a Roth IRA. We'll talk about the ordering rules in more detail, but don't think that you can take whatever you want out of your Roth IRA anytime you want with impunity.

Furthermore, Roth IRAs containing both conversions and regular contributions fall under a slightly different set of rules. It's still possible to remove your contributions (tax- and penalty-free), but the rules can get a bit more complex. We'll discuss 'em in detail in Part IV. For now, let's move on to the five-tax-year rule.

The Five-Tax-Year Rule

The first thing to understand is that "five tax years" is not necessarily the same as "five calendar years." The five-tax-year waiting period might be shorter than five calendar years, especially if a contribution is made after the close of the tax year to which it applies. Remember -- you have until April 15 of the following year to make a contribution for the current tax year. According to the law, the first year counted is the year for which the contribution is made, not the calendar year in which the contribution is actually made.

In effect, the very earliest date that a "normal" (i.e., no special issues such as death or disability) qualified Roth IRA distribution could possibly be made is January 1, 2003, because you couldn't contribute to a Roth IRA before January 1, 1998. The following example will bring this point home:

Example #2: Mike, at age 57, made a $2,000 contribution to his Roth IRA on April 15, 1999 for tax year 1998. On January 2, 2003, Mike withdraws $3,000 from his Roth IRA (he is over age 59-1/2). Of the $3,000 withdrawn, $2,000 represents the original contribution, and $1,000 represents the earnings.

This entire distribution is qualified, and is not included in Mike's taxable income because it was made after the five-tax-year period expired, and Mike was over age 59-1/2 when he took the distribution. For purposes of the five-tax-year rule in this example, 1998 counted as the first tax year, and the five-tax-year period expired at the end of 2002. So, even though Mike had his funds in his Roth IRA for less than five calendar years, he has met the five-tax-year rules, and his distribution is qualified.

Once the five-tax-year holding period is met, any distribution from the Roth IRA will be excludable as a qualified distribution if it is made after age 59-1/2 or if it meets one of the other requirements for a qualified distribution. But, this is only true as long as you only add contributions. If you add conversions to this account, those conversions will have their own five-tax-year holding period. This might be one very good reason to keep your conversions and contributions segregated in separate Roth IRA accounts. However, with respect to contributions, the first contribution or conversion begins the five-tax-year clock ticking. Still not clear? Then, let's take a look at Frank:

Example #3: Frank, age 58, makes a $2,000 contribution to a Roth IRA on April 15, 2000 for the 1999 tax year. Therefore, his five-tax-year clock started ticking in 1999.

In August of 2000, he makes his $2,000 contribution for tax year 2000. In January 2001, he makes his $2,000 contribution for 2001. In February 2003, he makes a $4,000 contribution ($2,000 each for tax years 2002 and 2003). In January 2004, when Frank is 62 years old, the value of his Roth IRA account is $15,000 ($8,000 in contributions and $7,000 of earnings). Frank takes a distribution of the entire balance of his Roth IRA account.

Is Frank's $15,000 distribution tax- and penalty-free? You bet your bippy!! The entire amount is a qualified distribution, and no part of the distribution will be subject to tax or penalty. Why? Because, at the time of the distribution, Frank was over age 59-1/2 and the five-tax-year period was met.

Frank's five-tax-year clock began ticking in 1999 (the tax year for which his first contribution was made) and expired on December 31, 2003. Since his distribution took place after the December 31, 2003 date, his entire distribution is qualified and not subject to taxes or penalties. All of the transactions that took place in his Roth IRA account after the initial contribution were meaningless for the five-tax-year holding rules.

Finally, you might be under the mistaken impression that Roth IRA contributions and conversions must be maintained in completely separate Roth IRA accounts. No longer true. The changes to the Roth IRA rules in the Tax Reform Act of 1998 made the need for these "separate" accounts moot. It's now acceptable to "co-mingle" your Roth IRA conversions and contributions, since the same five-tax-year rules apply to both. So, if your broker still insists that you segregate your conversion funds and contribution funds, tell him (or her) of the new law that removed the segregation restrictions.

But remember that there are still different five-year holding periods for conversions and contributions. Don't get lulled into thinking that, as long as your contribution holding period has been met, your conversion holding period has also been met.

That being said there may be times when you do want to maintain more than one Roth IRA account. Can't think of when that would be? Well, then check out my article entitled How Many Roth IRAs Do You Need? to find out.
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