Roth Distributions

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In determining the taxability of Roth IRA distributions, it is first necessary to determine if the distribution is a qualified distribution or a non-qualified distribution. IRS Publication 590 defines a qualified distribution as one that meets the following conditions:

1. It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for the taxpayer's benefit, and

2. The distribution is:

a. Made on or after the date the taxpayer reaches age 59 1/2, or
b. Made because the taxpayer is disabled, or
c. Made to a beneficiary or to the taxpayer's estate after death, or
d. Made to buy, build, or rebuild a first home as defined in code section 72(t)(8).

If a distribution does not meet the conditions of a qualified Roth distribution (defined above), then the distribution is a non-qualified distribution.


Taxability of Roth Distributions

Qualified Roth distributions are not subject to income tax or the additional 10% tax on early distributions. Non-qualified Roth distributions are subject to income tax only after all contributions to the Roth IRA have been returned. For this purpose, contributions include all regular contributions to the Roth IRA, and amounts converted from traditional IRAs to Roth IRAs in prior years. Thus, the only component of a Roth IRA that can be taxable is the earnings portion of the Roth IRA that is included in a non-qualified distribution.


Tax on Early Distributions

Non-qualified distributions from Roth IRAs may be subject to an additional 10% tax on early distributions, provided that none of the exceptions described in code section 72(t) apply. The amount subject to the additional tax depends on the amount of the distribution, basis in contributions, basis in conversions, years in which conversions were made, and the amount of earnings. As a general rule, returns of regular contributions (not to be confused with conversions), and returns of conversion contributions that were held in the IRA account for five years, are not subject to the 10% early distribution tax. However, returns of conversion contributions that were not held in the IRA account for five years, and earnings, are subject to the 10% early distribution tax. This requires diligent tracking of amounts contributed, amounts converted, and amounts previously distributed.

For the purpose of determining what distributed amounts represent, special ordering rules apply. Distributions are ordered as follows:

1. Regular contributions

2. The taxable amount of conversion contributions, on a first-in-first-out basis

3. The nontaxable amount of conversion contributions, on a first-in-first-out basis

4. Earnings on contributions


Examples:

The following examples show the application of the additional tax on early distributions (assuming that no exceptions apply).


Example A- Contribution Basis Only

John, age 45, began making contributions to a Roth IRA in 1998. He contributed $2,000 per year from 1998 to 2004, resulting in $14,000 of Roth contribution basis. John had no traditional to Roth conversions. In 2005, if John takes a Roth distribution of less than $14,000, none of the distribution is subject to income tax, and none of the distribution is subject to the 10% early distribution tax. If however, John takes a distribution in excess of $14,000, the amount distributed in excess of $14,000 is subject to both income tax and the 10% early distribution tax.


Example B – Conversion Basis Only; Five-year Holding Period Met

John, age 45, converted a $14,000 deductible traditional IRA to a Roth IRA in 1998. Thus all $14,000 was taxed in 1998 creating Roth conversion basis. John made no additional contribution to the Roth IRA, and did not convert any other amounts. In 2005, if John takes a Roth distribution of less than $14,000, none of the distribution is subject to income tax, and none of the distribution is subject to the 10% early distribution tax. This is because the five-year holding period on the conversion was met. If however, John taxes a distribution in excess of $14,000, the amount distributed in excess of $14,000 is subject to both income tax and the 10% early distribution tax.


Example C – Conversion Basis Only; Five-year Holding Period Not Met

John, age 45, converted a $14,000 deductible traditional IRA to a Roth IRA in 2002. Thus all $14,000 was taxed in 2002 creating Roth conversion basis. John made no additional contributions to the Roth IRA, and did not convert any other amounts. In 2005, if John takes a Roth distribution of less than $14,000, none of the distribution is subject to income tax, but the entire distribution is subject to the 10% early distribution tax. This is because the five-year holding period on the conversion was not met. If John takes a distribution in excess of $14,000, the amount distributed in excess of $14,000 is subject to income tax, and the entire distribution is subject to the 10% early distribution tax.


Example D – Contribution and Conversion Basis; Five-year Holding Period Met

John, age 45, converted a $14,000 deductible traditional IRA to a Roth IRA in 1998. Thus all $14,000 was taxed in 1998 creating Roth conversion basis. John also contributed $2,000 annually to the Roth IRA in tax years 2000 through 2004 creating Roth contribution basis of $10,000, for a grand total of Roth basis of $24,000. In 2005, if John takes a Roth distribution of less than $24,000, none of the distribution is subject to income tax, and none of the distribution is subject to the 10% early distribution tax. This is because returns of contribution basis are not subject to the additional 10% tax, and returns of conversion basis in which the five-year holding period is met are not subject to the additional 10% tax. If John takes a distribution in excess of $24,000 the amount distributed in excess of $24,000 is subject to both income tax and the 10% early distribution tax.


Example E – Contribution and Conversion Basis; Five-year Holding Period Not Met

John, age 45, converted a $14,000 deductible traditional IRA to a Roth IRA in 2002. Thus all $14,000 was taxed in 2002 creating Roth conversion basis. John also contributed $2,000 annually to the Roth IRA in tax years 2000 through 2004 creating Roth contribution basis of $10,000 for a grand total of Roth basis of $24,000. In 2005, if John takes a Roth distribution of less than $10,000, all of the distribution is considered a return of contributions (not conversions), and none of the distribution is subject to income tax, and none of the distribution is subject to the 10% early distribution tax. If John takes a Roth distribution greater than $10,000 but less than $24,000, none of the distribution is subject to income tax, but the amount distributed in excess of $10,000 is subject to the 10% early distribution tax because the five-year holding period was not met. If John taxes a Roth distribution greater than $24,000, the amount distributed in excess of $24,000 is subject to income tax, and the amount distributed in excess of $10,000 is subject to the 10% early distribution tax.


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