We've now reviewed the provisions in the law regarding the Roth IRA contribution (putting your cashin) and eligibility rules (the stick). Here we'll review the tax treatment of qualified distributions (getting your cash out) from the Roth IRA (the carrot).
Any qualified distribution from a Roth IRA is NOT included in gross income for individual tax purposes. Simple as that. In effect, 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 for qualified first-time homebuyer expenses.
But -- and this is a very big but -- even if one of the qualifications above is met, the distribution is STILL not qualified if it is made within a five-tax-year period. We'll see how to compute the five-tax-year holding period a bit later. Just know that five tax-years are NOT necessarily the same as five calendar years.
So, in effect, there are two sets of rules that must be met before a Roth IRA distribution becomes qualified, and therefore tax-free: The distribution rules and the five-tax-year rules. Unless both sets of rules are met, the distribution will NOT be qualified, and the earnings will be subject to tax, and possibly penalties. We'll discuss penalties in detail in the next article.
Bill, who is 25, makes a Roth IRA contribution of $2,000 this year. Seven years later (well beyond the five-tax-year period), Bill closes his Roth IRA and takes a distribution in the total amount of $4,500 (representing the original $2,000 contribution and $2,500 in earnings). 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, the distribution is NOT qualified. Bill will owe income taxes on the $2,500 of earnings. Additionally, Bill will be assessed a 10% early withdrawal penalty on this $2,500 of earnings unless he meets one of the other six authorized exceptions for avoiding that penalty. 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 since 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 the next article, 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 the next article as well. For now, let's move on to the five-tax-year rule.
The Five-Tax-Year Rule
Let's take a few minutes to discuss the five-tax-year rule. The waiting period for a qualified distribution may be shorter than five calendar years, especially if a contribution is made after the close of the tax year for which it is recognized. Remember that you have until April 15 of the following year to make a contribution for the current tax year. And, according to the law, the first year that is 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 would be Jan. 1, 2003 because you were not able to contribute to a Roth IRA prior to Jan. 1, 1998.
Mike, at age 57, made a $2,000 contribution to his Roth IRA on April 15, 1999 for tax year 1998. On Jan. 2, 2003, Mike withdraws $3,000 from his Roth IRA when 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, so the five-tax-year period expired at the end of 2002. 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. Keep in mind that each conversion from a traditional IRA will have its own individual 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 annual contributions only, the first contribution or conversion begins the five-tax-year clock ticking. Still not clear? Then let's take a look at Frank.
Frank, age 58, converts a $2,000 traditional IRA to a Roth IRA on April 15, 1999. Therefore, his five-tax-year clock started ticking in 1999.
In August of 2000, he makes a $2,000 annual 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 for his original conversion was met.
Frank's five-tax-year clock began ticking in 1999 (the tax year in which he made his first contribution through the conversion of his traditional IRA), and it expired on Dec. 31, 2003. Since his distribution took place after Dec. 31, 2003, 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 conversion 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. The five-tax-year holding period for conversions begins in the tax-year each conversion is made.
Next we'll look at the issue of early withdrawals from Roth IRAs.