Roth IRAs: Distributions

The tax treatment of a Roth IRA distributions depends on whether the distribution is qualified. Qualified distributions from Roth IRAs are tax and penalty free, but nonqualified distributions could be subjected to tax and/or the 10% early distribution penalty.

Qualified Distributions Defined

For a distribution to be qualified, it must occur at least five years after the Roth IRA owner established and funded his/her first Roth IRA, and the distribution must occur under at least one of the following conditions:

  • The Roth IRA owner is at least age 59½ when the distribution occurs.
  • The distributed assets are used toward the purchase, or to build or rebuild a first home for the Roth IRA owner or a qualified family member. Qualified family members include the IRA owner's spouse, a child of the IRA owner and/or of the IRA owner's spouse, a grandchild of the IRA owner and/or of his or her spouse, a parent or other ancestor of the IRA owner and/or of his or her spouse. This is limited to $10,000 per lifetime.
  • The distribution occurs while the Roth IRA owner is disabled.
  • The assets are distributed to the beneficiary of the Roth IRA owner after the Roth IRA owner's death.

For example, if an individual establishes a Roth IRA at ABC Brokerage in 2017 and establishes a second Roth IRA at XYZ Brokerage in 2018, the five-year period that is used to determine if a distribution is qualified begins on January 1, 2017, the first day of the year for which the first contribution is made. This is true even if the 2017 contribution was made at anytime up to April 15, 2018.

How Are Non-Qualified Distributions Taxed?

A nonqualified distribution is any distribution is not a qualified distribution.

A non-qualified distribution may be subjected to income tax and/or the 10% early-distribution penalty. The source of a non-qualified distribution determines the applicable tax treatment. Roth IRA distributions can come from the following four sources:

  1. Regular contributions
  2. Roth IRA conversions, on a first in, first out basis. These are further distributed in the following order:
    • Roth conversion of taxable traditional IRA assets (traditional IRA assets for which a tax deduction was allowed) or a rollover of taxable assets from a qualified plan, 403(b) or governmental 457(b) plan. These assets are taxed when converted to the Roth IRA.
    • A Roth conversion of nontaxable traditional IRA assets (traditional IRA assets for which there was no tax deduction, of after-tax amounts rolled over to the traditional IRA.), or a rollover of nontaxable assets from a qualified plan or 403(b) plan. These assets are not subjected to income tax when distributed or converted to a Roth IRA.
  3. 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. Note: When assets from one source are used up or non-existent, the assets are distributed from the next source in the list:

  1. regular Roth IRA contributions
  2. taxable traditional IRA conversions and taxable rollovers from qualified plans, 403(b) or governmental 457(b) plans
  3. nontaxable traditional IRA conversions and nontaxable rollovers from qualified plans and 403(b) plans
  4. earnings on all Roth IRA assets

The following chart summarizes the tax treatment of Roth IRA distributions.

Distributed Assets Qualified Distributions Non-Qualified Distributions Comments
Regular Contributions – Tax free
– Penalty free
– Tax free
– Penalty free
Income tax and the 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/taxable rollover – Tax free
– Penalty free
– Tax free
– Penalty may apply
- Already taxed when converted or rolled over.
- Penalty is waived if any one of the exceptions applies and/or it has been at least five years since the conversion occurred.
Nontaxable Conversion/nontaxable rollover – Tax free
– Penalty free
– Tax free
– Penalty free
Income tax and penalty are never applied to distributed assets for which no deduction was allowed when the assets were initially contributed to the IRA. For qualified plans and 403(b), these amounts are attributed to after-tax contributions made to the participant's account.
Earnings – Tax free
– Penalty free
– Taxable
– Penalty may apply
Penalty is waived if any one of the exceptions applies.

The tax treatment of a Roth IRA distribution depends on whether the distribution is qualified. Qualified distributions from Roth IRAs are tax and penalty free, but nonqualified distributions could be subjected to tax and/or the 10% early distribution penalty.

Example: Tax and Penalty Free Roth IRA Distribution

Harry established his first Roth IRA in 2013 and funded it with $2,000 as a regular contribution. From 2014 through 2017, he made additional regular contributions, and Harry also converted his traditional IRA assets to his Roth IRA in 2017. The balance in Harry’s Roth IRA is represented as follows:

Assets

Source

$10,000

Regular Roth IRA contributions 2013 through 2017

$20,000

Taxable traditional IRA conversions from 2017 conversion

$5,000

Nontaxable Roth IRA conversions from 2017 conversion

$2,000

Earnings

$37,000

 
 

Harry wants to know the tax consequences should he distribute the assets from his Roth IRA during 2018.

Because Harry has had a Roth IRA for at least five years (2013 to 2017), his distributions will be tax and penalty free if he meets one of the following criteria:

  • He is at least age 59½ when the distribution occurs.
  • The distributed assets are used toward the purchase or to rebuild a first home for Harry or a qualified family member.
  • The distribution occurs after Harry becomes disabled.
  • The assets are distributed to Harry's beneficiary after his death.
 

Example: Roth IRA Distribution Penalty

In this example, Harry established his first IRA in 2014 rather than 2013, so he cannot make a qualified distribution until January 1, 2019. Should Harry distribute the full balance of his Roth IRA in 2018, it will be treated as follows:

  • The $10,000 representing regular contributions will be tax and penalty free. These amounts can be distributed at any time without tax and penalty because no deductions were allowed when they were contributed.
  • The $5,000 representing nontaxable conversion will be tax and penalty free. These amounts can be distributed at any time without tax and penalty because no deductions were allowed when they were contributed.
  • The $20,000 representing taxable conversion assets will be tax free because the taxes were paid when the assets were converted. However, because it has been less than five years since the conversion occurred, Harry will owe the IRS a 10% early-withdrawal penalty unless he meets one of the criteria listed below in the next section.
  • The $2,000 representing earnings will be subjected to income tax. In addition Harry will owe the IRS a 10% early-withdrawal penalty, unless he meets an exception.

Some exceptions to the 10% early-withdrawal penalty:

– He uses the assets to pay unreimbursed medical expenses.

– He withdraws the assets when he is at least age 59½.

– He uses the assets to pay medical insurance.

– He withdraws the assets while disabled.

–The assets are distributed by his beneficiary after his death.

–The distribution is part of a SEPP program for getting payments from the IRA.

–The assets are used for qualified higher education expenses.

–The assets are used for a first home purchase.

– The assets are used to pay an IRS levy.

 

The 10% early-distribution penalty does not apply to certain amounts that are not subject to income tax. These include amounts that were contributed in excess of the contribution limit and are then removed from the Roth IRA before the Roth IRA owner's tax-filing deadline (plus tax-filing extensions). Other amounts that are not subject to income tax are those deposited to a retirement plan as a rollover contribution within 60 days of receipt.

Key Reminders

  • If a Roth IRA holder completed multiple Roth conversions, the five-year period for each Roth conversion is determined separately for each conversion.
  • For the purposes of 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.

Required Minimum Distributions

The rules for required minimum distributions (RMDs) do not apply to the Roth IRA owner. They do, however, apply to the Roth IRA owner’s beneficiary.

Roth IRAs: Conclusion