Tax Treatment Of Roth IRA Distributions

The Tax Payer Relief Act of 1997 created the Roth IRA, which was made effective for tax years beginning 1998. Prior to 1998, individuals who wanted to fund an IRA could make either a deductible or nondeductible contribution to a Traditional IRA. But distributions from Traditional IRAs are generally treated as ordinary income and may be subject to income tax as well as an additional early-distribution penalty if the withdrawal occurs while the IRA owner is under the age of 59.5. The Roth IRA, on the other hand, allows qualified distributions to be free from tax and penalties. Here we review the tax treatment of Roth IRA distributions.

Defining Qualified Distribution
Distributions from a Roth IRA that are not qualified may be subject to income tax and an additional 10% early-distribution penalty. A qualified distribution meets both of the following two categories of requirements:

It occurs at least five years after the Roth IRA owner established and funded his or her first Roth IRA*.
It is distributed under one of the following circumstances:
- The Roth IRA holder is at least age 59.5 when the distribution occurs.
- The Roth IRA holder becomes disabled before the distribution.
- The beneficiary of the Roth IRA holder receives the assets after his or her death.
- The distributed assets will be used towards the purchase or rebuilding of a first home for the Roth IRA holder or a qualified family member. This is limited to $10,000 per lifetime. Qualified family members include the following:
  - the Roth IRA holder
  - the Roth IRA holder's spouse
  - the children of the Roth IRA holder and/or his or her spouse
  - the grandchild of the Roth IRA holder and/or his or her spouse
  - the parent or other ancestor of the Roth IRA holder and/or his or her spouse\

*For this purpose, all Roth IRAs of an individual are counted for determining the five-year period. For example, if an individual established a Roth IRA at ABC Brokerage in 2000, and established a second Roth IRA at XYZ Brokerage in 2005, the five-year period begins year 2000. The five-year period begins with the first day of the year for which the first contribution was made. For example, if the first Roth IRA contribution was made for 2000, the five-year period begins Jan 1, 2000. This is true even if the 2000 contribution is made in 2001 before the deadline of Apr 15, 2001.

How Are Nonqualified Distributions Taxed?
The tax implication of a nonqualified distribution depends on the source of the Roth IRA assets. There are four possible sources of Roth IRA assets:

Regular participant contributions.
A Roth conversion of taxable Traditional IRA assets (i.e. Traditional IRA assets for which a tax deduction was allowed. These assets are taxed when converted to the Roth IRA).
A Roth conversion of nontaxable Traditional IRA assets (i.e. Traditional IRA assets for which there was no tax deduction. These assets are not subjected to income tax when distributed or converted to a Roth IRA.)
Earnings on all Roth IRA assets.

To determine the source of assets distributed from a Roth IRA, the IRS uses the 'ordering rules'. According to the ordering rules, assets are distributed from a Roth IRA in the following order (once assets from one source run out, the assets from the next source are distributed):

regular Roth IRA participant contributions.
taxable Traditional IRA conversions.
nontaxable Traditional IRA conversions.
earnings on all Roth IRA assets.

Distributions of Roth IRA assets from regular participant contributions and from nontaxable conversions of Traditional IRA can be taken at anytime, tax and penalty free - that is, if the distribution is in line with the rules that exempt assets from income tax and early-distribution penalties. A nonqualified distribution of taxable Traditional IRA conversion assets may be subjected to early-distribution penalties. And finally, a nonqualified distribution of earnings may be subjected to income tax and the early-distribution penalty. The following illustration shows when taxes and the early-distribution penalty apply to nonqualified distributions.

An Example
John established his first Roth IRA in 2000 and made a participant contribution of $2,000 a year. In 2004 he converted his Traditional IRA assets to his Roth IRA. In 2005, John is 55 years old, and the balance in John's Roth IRA at that time is represented as follows:

Assets	Source
$10,000	Roth IRA participant contributions 2000 through 2004
$50,000	Taxable Traditional IRA conversions from 2004
$10,000	Non-taxable Roth IRA conversions from 2004
$5,000	Earnings
$75,000

John wants to know the tax consequences should he distribute assets from his Roth IRA in 2005. Remember that assets are distributed in the following order: (1) participant contributions, (2) conversions and (3) earnings. We will use examples of various 2005 distribution amounts from John's Roth IRA to show their tax treatment.
Distribution of $10,000
If John takes a distribution of $10,000, it will be tax and penalty free because of the following reasons:

According to the ordering rules, John's distribution comes from his regular participant contributions until these are used up.
According to the regulations, a distribution of regular contributions is always tax and penalty free, regardless of when the distribution occurs. There is no waiting period.

Distribution of $25,000
If John takes a distribution of $25,000, the first $10,000 comes from his regular Roth IRA contributions and is therefore tax and penalty free. The additional $15,000, however, comes from his taxable conversion assets. Because these assets were taxed when converted, there will not be any income tax owed on the distribution.

While these assets are not subjected to income tax, they are subjected to the 10% early-distribution penalty, unless it has been five years since the assets were converted. Unfortunately, it hasn't been five years since John's conversion. But, the penalty may still be waived if John meets one of the following nine criteria:

He is at least age 59.5 when the distribution occurs. (John is only 55, so this does not apply).
He plans to use the distribution towards the purchase or rebuilding of a first home for himself or a qualified family member. This is limited to $10,000 per lifetime. (We list who is included as a qualified family member above in the section "Defining Qualified Distribution".)
John becomes disabled before the distribution occurs.
John's beneficiary receives the assets after John's death.
He uses the assets for medical expenses for which he was not reimbursed.
His distribution is part of an SEPP program (about which you can read in Rules Regarding Substantially Equal Periodic Payment (SEPP)).
John uses the assets for higher-education expenses.
John uses the assets to pay for medical insurance after losing his job.
His assets are distributed as a result of an IRS levy.

If John does not meet any of these requirements, the additional $15,000 will be subjected to a 10% early-distribution penalty.

Distribution of $70,000
Like the first $10,000 distributed in the two preceding examples, the first $10,000 here is tax and penalty free. The next $50,000 will be attributed to taxable conversion assets, which will not be subjected to taxes because they were taxed when converted. The additional $10,000 is attributed to nontaxable conversion assets. These will not be subjected to taxes or the early-distribution penalty because no deduction was allowed when they were contributed to the Traditional IRA.

Distribution of $75,000
Withdrawn amounts up to $70,000 will be treated as in the example above. Since John has had his Roth IRA for five years, the earnings ($5,000) will be tax and penalty free if he meets one of the following four criteria:

He is at least age 59.5 when the distribution occurs. (John is only 55, so this does not apply.)
John uses the distributed assets toward the purchase or rebuilding of a first home for himself or a qualified family member. This is limited to $10,000 per lifetime. (We list who is included as a qualified family member above in the section "Defining Qualified Distribution".)
John becomes disabled before the distribution occurs.
John's beneficiary receives the assets after John's death.

If none of these four exceptions apply, the earnings of $5,000 will be subjected to taxes and the 10% early-distribution penalty.

The following chart summarizes the tax treatments of the assets in John's Roth IRA:

Assets	Source	Tax and Penalty Treatment	Comment
$10,000	Regular Roth IRA participant contributions, 2000 through 2004	Always tax and penalty free, regardless of when distributed.
$50,000	Taxable Traditional IRA conversions from 2004 conversion	Will be subjected to the 10% early-distribution penalty, unless distributed five years after the conversion occurs, or one of the nine penalty exceptions (see complete list above) applies.	Cannot be accessed until all regular Roth IRA participant contributions are fully distributed from all of John's Roth IRAs.*
$10,000	Nontaxable Roth IRA conversions from 2004 conversion	Always tax and penalty free, regardless of when distributed.	Cannot be accessed until all regular Roth IRA participant contributions and taxable conversion assets are fully distributed from all of John's Roth IRAs.*
$5,000	Earnings	May be subjected to income tax and early-distribution penalty unless the distribution is qualified. If the distribution is nonqualified, income tax will apply. The 10% early-distribution penalty will be waived if one of the four exceptions (see complete list above) applies.	Cannot be accessed until all regular Roth IRA participant contributions and conversion assets are fully distributed from all of John's Roth IRAs.

*Each conversion has its own five-year period: for a conversion that occurs in 2000, the five-year period ends Dec 31, 2004. And for a conversion that occurs in 2004, the five-year period ends Dec 31, 2008.

Summary
The following chart summarizes the tax treatment of all possible Roth IRA distributions:

Distributed Assets	Qualified Distributions	Nonqualified Distributions	Comment
Regular participant contributions	Tax free and penalty free	Tax free and penalty free	Income tax and early-distribution penalty are never applied to distributed assets for which no deduction was allowed when the assets were contributed to the IRA.
Taxable conversion	Tax free and penalty free	Tax free but penalty may apply	These are already taxed when converted. Penalty is waived if any one of the exceptions apply.
Nontaxable conversion	Tax free and penalty free	Tax free and penalty free	Income tax and penalty is never applied to distributed assets for which no deduction was allowed when the assets were initially contributed to the IRA.
Earnings	Tax free and penalty free	Taxes apply and penalty may apply	Penalty is waived if any one of the exceptions apply.

Some Final Key Points

If an IRA holder completes multiple Roth conversions, the five-year period for each Roth conversion is determined separately for each conversion.
For determining qualified distributions, there is only one five-year period. This never starts over.
If an excess contribution is made to a Roth IRA and later removed, this contribution cannot be used to determine the five-year period for qualified distributions.

The responsibility of determining the tax and/or penalty treatment of distributed Roth IRA assets rests with the Roth IRA owner. Roth IRA owners should ensure that they keep proper records of their Roth IRA transactions and that they file the applicable tax forms with the IRS at the appropriate time.

Just because you can distribute your retirement assets before you reach retirement age does not mean we advocate doing so: the information above is just a review of the Roth IRA rules and is intended to help individuals understand them should they need to distribute assets from Roth IRA.

Individual taxpayers must seek competent professional assistance to ensure Roth IRA transactions are handled properly.

by Denise Appleby (Contact Author | Biography)

Denise Appleby is a retirement plans consultant, freelance writer and editor. Before starting her own business, Appleby Retirement Consulting, Denise worked for Pershing LLC for almost 10 years. While at Pershing, Denise rose to the rank of vice president, and held many positions including retirement plans product manager, manager of the retirement plans technical assistance group and retirement plans training manager. Appleby Retirement Consulting provides technical assistance to financial institutions and financial professionals; content for newsletters, websites and magazines; and technical editing services for books and other retirement plans material. Denise holds several retirement professional designations.