The Taxpayer 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 would usually open an account with one of the top Roth IRA brokers and then 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 59½. 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
First of all, let's be clear as to terms: Distributions of Roth IRA assets from regular participant contributions and from nontaxable conversions of a Traditional IRA can be taken at any time, tax- and penalty-free. They are always qualified distributions. So the taxes and penalties mainly come into play when we're talking about withdrawing the earnings from a Roth IRA – that is, amounts that exceed what the participant has invested in the account.
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:
1. It occurs at least five years after the Roth IRA owner established and funded his or her first Roth IRA*.
2. It is distributed under one of the following circumstances:
- The Roth IRA holder is at least age 59½ 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 toward 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 ancestors 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 2017, and established a second Roth IRA at XYZ Brokerage in 2018, the five-year period begins in 2017. 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 2017, the five-year period begins Jan 1, 2017. This is true even if the 2017 contribution is made in 2018 by the deadline of April 15, 2018.
How Are Nonqualified Distributions Taxed?
The tax implication of a non-qualified 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 or rollover of taxable assets (Traditional IRA assets for which a tax deduction was allowed and pretax amounts from employer plans such as qualified plans, 403(b) and governmental 457(b) plans. These assets are taxed when converted or rolled over to the Roth IRA).
- A Roth conversion or rollover of nontaxable assets (Traditional IRA assets for which there was no tax deduction and after-tax assets from employer plans such as qualified plans and 403(b) plans). 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 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):
1. Regular Roth IRA participant contributions
2. Taxable conversion and rollover amounts
3. Nontaxable conversion and rollover amounts
4. Earnings on all Roth IRA assets
Under the ordering rules applicable to Roth IRAs, contributions and converted assets are always deemed to be withdrawn before earnings. Roth conversion amounts are not considered distributed until all contribution amounts have been distributed; earnings are not considered distributed until all contribution – and then all conversion – amounts have been distributed.
Distributions of Roth IRA assets from regular participant contributions and from nontaxable conversions of a Traditional IRA can be taken at any time, tax- and penalty-free. A nonqualified distribution of taxable Traditional IRA conversion assets may be subject to early-distribution penalties. And finally, a nonqualified distribution of earnings may be subject to income tax and the early-distribution penalty. The following illustration shows when taxes and the early-distribution penalty apply to nonqualified distributions. (To learn more about how to avoid tax, see Avoiding Too Much Tax On Your Distributions.)
John established his first Roth IRA in 2016 and made a participant contribution of $5,000 a year. In 2016, he converted his Traditional IRA assets to his Roth IRA. In 2018, John is 55 years old, and the balance in John's Roth IRA at that time is represented as follows:
|$10,000||Roth IRA participant contributions 2016 and 2017|
|$50,000||Taxable Traditional IRA conversions from 2016|
|$10,000||Non-taxable Roth IRA conversions from 2016|
John wants to know the tax consequences should he distribute assets from his Roth IRA in 2018. Remember that assets are distributed in the following order: (1) participant contributions, (2) conversions and (3) earnings. We will use examples of various 2018 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 exceptions, which include the following:
- He is at least age 59½ when the distribution occurs. (John is only 55, so forget this.)
- He plans to use the distribution to buy or rebuild a first home for himself or a qualified family member. This is limited to $10,000 per lifetime.
- John becomes disabled before the distribution occurs.
- John's beneficiary distributes the assets after John's death.
- John uses the assets for eligible medical expenses for which he was not reimbursed.
- John's distribution is part of an SEPP program
- John uses the assets for higher-education expenses.
- John uses the assets to pay for medical insurance after losing his job.
- John's assets are distributed as a result of an IRS levy.
- The amount is rolled over within 60-days, if eligible.
If John does not meet any of these requirements, the additional $15,000 will be subject 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 subject to income tax because they were taxed when converted. However, the $50,000 is subject to the 10% early-distribution penalty, unless it has been five years since the assets were converted (which is not the case in this example), or if John meets one of the exceptions listed above under the example ‘Distribution of $25,000'. The additional $10,000 is attributed to nontaxable conversion assets. These will not be subject 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 of up to $70,000 will be treated as in the example above. Because John has not had his Roth IRA for five years, the earnings ($5,000) will be subject to income tax. The withdrawal will also be subject to the 10% penalty, unless John qualifies for an exception.
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,||Always tax- and penalty-free, regardless of when distributed.|
|$50,000||Taxable Traditional IRA conversions from 2016 conversion||Will be subjected to the 10% early-distribution penalty, unless distributed five years after the conversion occurs, or one of the 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 2016 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 Joh\'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 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 2017, the five-year period ends December 31, 2016. For a conversion that occurs in 2018, the five-year period ends December 31, 2017.
Tax Treatment Chart
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
|Tax free and
|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
|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
|Tax free and
|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
|Taxes apply and penalty may apply||Penalty is waived if any one of the exceptions apply.|
The Bottom Line
If an IRA holder completes multiple Roth conversions, the five-year period is determined separately for each conversion. For determining qualified distributions, there is only one five-year period; it 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. Individual taxpayers must seek competent professional assistance to ensure it's a good idea, and that the Roth IRA transactions are handled properly.