Non-Qualified Distribution

What Is a Non-Qualified Distribution?

A non-qualified distribution can refer to two scenarios: either a distribution from a Roth IRA that occurs before the IRA owner meets certain requirements or a distribution from an education savings account that exceeds the amount used for qualified education expenses.

Understanding Non-Qualified Distributions

The distinction between qualified and non-qualified retirement plans is worth noting. Qualified retirement plans give members tax benefits—with employers deducting certain pretax wages from employees—that can increase tax-deferred until withdrawn. Unlike qualified plans, non-qualified plans are not eligible for tax deferral benefits under the Employee Retirement Income Security Act (ERISA); as a result, contributions to non-qualified plans can be taxed.

Key Takeaways

  • Non-qualified distributions refer to either distributions from Roth IRAs or education savings accounts when certain conditions are met.
  • Earnings distributed from non-qualified education savings plans are taxable and may be subject to a 10% IRS early withdrawal penalty.
  • Qualified Roth IRA distributions must meet certain criteria, such as the account owner must be at least 59½ and the account at least five years old.
  • Non-qualified Roth distributions are taxed as income and may be subject to the IRS premature withdrawal penalty.

Non-Qualified Distributions in Education Savings vs. Roth IRAs

The two main types of non-qualified distribution are with education savings accounts and Roth IRAs. For education savings, "non-qualified distribution may be subject to a 10 percent federal income tax penalty in addition to any income taxes that may be due," as one state agency explains:

There may also be state tax consequences. The earnings portion of a non-qualified distribution is taxable to the individual who receives the payment, either the account owner or the designated beneficiary. If the payment is not made to the designated beneficiary or an eligible educational institution for the benefit of the designated beneficiary, it will be deemed to have been made to the account owner.

As for Roth IRAs, qualified distributions usually require that the account is at least five years old, with the account holder more than 59½ years old, making a withdrawal due to a first-time home purchase or due to disability or death. Withdrawals that don’t fit those criteria are generally classified as non-qualified Roth IRA distributions.

However, you are allowed to withdraw any contributions that you made to a Roth IRA tax-free and penalty-free at any age without the account needing to be five years old. Though this rule applies only to contributions, the earnings that your account generates on those contributions are not included.

Additionally, it's worth noting that non-qualified Roth distributions are taxed as income. You will also be subject to an IRS 10 percent early withdrawal penalty if you are younger than 59½. Depending on your tax bracket, this can add up to a considerable sum. If you have to take an early distribution for any reason, understanding the rules that determine whether it is a qualified or non-qualified Roth IRA distribution can help you minimize the amount of taxes and penalties to which you may be subject.