Roth IRA - Part V

Death & Taxes

Roth IRA, Part V
Distribution Ordering Rules

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By Roy Lewis

In Part IV, we discussed the various penalties associated with an "early" distribution from your Roth IRA and the exceptions to the penalties. We mentioned that the rules could get a bit complex if you decided to remove funds early after electing to "spread out" the income from your 1998 conversion. We also told you that Uncle Sammy had "ordering" rules that must be followed if you remove funds "early" from your Roth IRA. So, let's discuss those last two very important issues.

Income Acceleration

Those who converted their regular IRA to a Roth IRA in 1998 had an additional decision to make. They could recognize the entire amount of the conversion as income in the year of the conversion -- or they could elect to spread out the income over four years. Note: Today the income spread is no longer available -- you are required to report all of your conversion income in the year of conversion.

If you converted your IRA in 1998, chose to spread out the income over four years, and have now decided to remove those funds early from your Roth IRA, how do you deal with the income and penalty issues? Well, you'll run afoul of the "income acceleration" rules. Or, at least you would have run afoul of those rules if you had read this article in 1999 or 2000. Starting in 2001, which is the fourth year of the four-year spread, the income acceleration rules no longer apply. But, if you're still working on your 2000 tax return and took an early Roth IRA distribution in 2000 that might impose the income acceleration rules, we'll give you the complete skinny on them. Here's how the rules worked:

The law says that, if you withdraw converted funds in any tax year before the last year of the four-year spread (2001), you'll have to include in income any amounts withdrawn that have not yet been subject to tax. The rules are a lot more technical than this simple sentence, but who cares?! If you've been good Fools and filed your prior-year tax returns on a timely basis, this isn't important to you for tax-year 2001 and later. But, if you're here trying to figure out how the laws might have impacted a 1999 or 2000 distribution that might have triggered the income acceleration rules, then read on.

Example #1: Susan had a regular IRA with a value of $40,000, consisting entirely of deductible contributions and earnings. Susan converted this regular IRA to a Roth IRA in 1998, and decided to use the four-year income spread. Susan reports $10,000 in income for each of the four years beginning with 1998 ($40,000 divided by 4 = $10,000).

In early 1999, Susan made an early withdrawal of $12,000 from her converted Roth IRA. Therefore, on her 1999 tax return, Susan had to report $22,000 in gross income related to her Roth IRA conversion. This $22,000 consists of the regular $10,000 amount required because of the four-year income spread election, plus the $12,000 withdrawal.

On her tax return for 2000, Susan is required to include $8,000 in gross income from her Roth conversion, since that is all that is left of the original four-year spread amount ($10,000 reported in 1998, $22,000 reported in 1999, and $8,000 to be reported in 2000 amounts to the initial $40,000 on which tax was due).

In 2001 (the fourth year under the four-year spread), Susan will not be required to include any additional amounts in her gross income, since the taxable amounts were previously reported and taxed because of the early withdrawal.

With respect to penalties, Susan would pay an additional $1,200 in penalties on the $12,000 distribution taken in 1999, assuming that she doesn't qualify for any of the exceptions to the penalty.

In effect, if you take an early distribution from a conversion that you decided to "spread," you are required to take the distribution from the "back end" of the spread -- and include that income with the normal "spread" income that you would otherwise be required to report in the year in question. That's your spankin' from Uncle Sammy for deciding to take a distribution before your four-year spread period has expired. Ouch!

IRS Ordering Rules

Here's another complication in the life of a Roth IRA account holder. What if you have contributions, conversions, and earnings all mixed up in the same account and you decide to take a distribution? What are you really taking? Well, the IRS has deemed that Roth IRA distributions must be withdrawn in the following order:
  • First, from contributions to the Roth IRA (other than conversion amounts)
  • Second, from conversions, on a first-in, first-out (FIFO) basis
  • Third, from earnings
Who cares? You might -- especially if you find that you have to take an early withdrawal. Let's look at another example:

Example #2: Ima Mess converted $80,000 from a regular IRA to a Roth IRA in 1998. Of the amount converted, $20,000 represented prior non-deductible traditional IRA contributions and $60,000 represented earnings on which Ima needs to pay taxes. Ima decided to spread her taxable income attributable to this conversion over four years (as was permitted in 1998). So, she is required to include $15,000 in income ($60,000 divided by 4 equals $15,000) for each of the next four years, beginning with 1998.

In 1998, she also made a $2,000 annual contribution to the Roth IRA. In 1999, the value of the Roth IRA was $92,000 ($80,000 converted, $10,000 in earnings on the converted funds, and $2,000 in contributions). At that time, Ima withdrew $25,000 from the Roth.

So, the ordering rules come into play here. Of the amount withdrawn, $2,000 was treated as a tax-free (and penalty-free) withdrawal of the $2,000 contribution she made in 1998. The next $23,000 was treated as coming from the converted funds.

On her 1999 tax return, Ima had to include $38,000 in gross income related to her IRA conversion and early withdrawal. Why? Because of the income acceleration rules noted above. The $38,000 includes the $15,000 required from the normal income spread and the $23,000 taxable portion of the early withdrawal she took.

Since she paid taxes on $15,000 of the converted funds in 1998, and $38,000 in 1999, in 2000 she'll report $7,000 as the remaining taxable portion of the original $60,000 income spread. In 2001 she won't be required to report any additional income under the four-year-spread rules (since these amounts were accounted for in previous years).

With respect to penalties, Ima will get hit with a penalty of $2,300 (10% of the taxable distribution) in 1999.

So, there you have it. The moral of the story: Keep your hands off of your Roth IRA funds. (Just kidding there.) But seriously, you can see how complicated the reporting can become. So, unless you're able to do a lot of reading on the Roth IRA distribution rules, you might just want to leave the account alone if you possibly can.

Finally, speaking of conversions, what if you made a conversion from a traditional IRA early in the year, but now find out (because your income screamed past the $100,000 AGI limits for allowed conversions) that you don't qualify to make a conversion?

Yikes. The conversion was already made. Is there a way to get the genie back in the bottle? Yup... there sure is. It's called a recharacterization from the Roth IRA back to a traditional IRA. We'll discuss recharacterizations in detail in Part VI. Pretty exciting, eh? Don't touch that dial!
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