Roth IRA Distributions—What’s taxable and what’s not?

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IRA/CESA/HSA - Article

Roth IRA Distributions
What’s taxable and what’s not?

Diana Theis, IRA Consultant, Wolters Kluwer Financial Services
Aug 2006

Outline

Ordering Rules

Regular/Spousal Contribution Amounts

Conversion Contribution Amounts

Roth IRA Earnings

Reporting Roth IRA Distributions

Simply Stated

Since Congress created Roth individual retirement accounts (IRAs) in 1997, millions of taxpayers have signed on to the idea of tax-free distributions. However, the idea and reality are not always one and the same. So, how does a person know what’s taxable and what’s not? This article will break down the Roth IRA ordering rules—the rules that help determine taxation of Roth IRA distributions—and review the Roth IRA owner and Roth IRA custodian/trustee reporting responsibilities.

Ordering Rules
When taking distributions, a Roth IRA owner treats all of his/her Roth IRAs as one Roth IRA. For example, if Marty has a Roth IRA at ABC Bank, another Roth IRA at XYZ Credit Union, and a third through a mutual fund family, Marty will treat them as a single Roth IRA for distribution purposes. [Treasury Regulation Section 1.408A-6, Q 9]

A Roth IRA owner removes Roth IRA contributions and earnings in the following order:

Regular/spousal contributions
Traditional IRA conversion contributions on a first-in, first out basis with taxable amounts before nontaxable (basis) amounts
Earnings on all Roth IRA contributions

Regular/Spousal Contribution Amounts
Regular/spousal contributions for a tax year are the first distributed from a Roth IRA. Because regular/spousal Roth IRA contributions are not deductible, they are not taxable nor subject to the 10 percent penalty tax when withdrawn, regardless of the IRA owner’s age.

Example
Sara contributed $2,000 to her Roth IRA at ABC Bank in 2002; $2,000 to her Roth IRA at XYZ Credit Union in 2003; and $3,000 to her Roth IRA at MNO Mutual Fund Company in 2004. Her earnings total $750.

Treating all of her Roth IRAs as one, Sara can withdraw up to $7,000 (her combined contributions) before she has a potential taxable distribution from any of her Roth IRAs.

Conversion Contribution Amounts
The distribution of assets converted from traditional IRAs follows distribution of regular/spousal contributions in the ordering sequence. These Roth IRA assets are nontaxable on distribution because they were subject to income tax when converted from a traditional IRA. The amount attributable to the taxable portion of the traditional IRA distribution is considered withdrawn from a Roth IRA before the nontaxable amount.

Conversion amounts are subject to a 10 percent penalty tax if distributed within five years of the year of conversion. If an individual completes conversions in multiple years, each conversion amount has a different five-year period during which a penalty tax may apply. Distributions occur in the order contributed—first in, first out. The penalty tax does not apply if the Roth IRA owner meets an exception to the 10 percent penalty tax for early withdrawal.

Conversion Contributions
A traditional IRA may contain taxable amounts (deductible contributions, pretax rollovers, and earnings) and nontaxable amounts (nondeductible contributions and after-tax qualified employer plan rollover assets) called basis. Upon distribution from a traditional IRA, the taxable amounts become ordinary income. If an IRA owner has basis, he/she files Internal Revenue Service (IRS) Form 8606, Nondeductible Contributions, with his/her federal income tax return to determine the taxable portion of a traditional IRA distribution, even one converted to a Roth IRA.

Examples
Converted assets removed during the five-year penalty period

Steve, age 38, completed the conversion of two of his traditional IRAs to a Roth IRA─one in 2003 and the other in 2004. The 2003 conversion amount was $14,000; $10,000 taxable and $4,000 nontaxable. The 2004 conversion was $6,000; $5,000 taxable and $1,000 nontaxable. Steve has no other Roth IRAs and made no other contributions to this Roth IRA.

Assume that Steve needs to withdraw $16,000 in 2006 for a family emergency. No exception to the 10 percent penalty tax applies. His distribution sequence is $14,000 from the first (2003) conversion─$10,000 taxable and $4,000 nontaxable─followed by $2,000 of the second (2004) conversion’s taxable portion. Steve will owe the 10 percent penalty tax on $12,000─the $10,000 from the 2003 conversion and $2,000 from the 2004 conversion.

Converted assets removed after the five-year penalty period

Assume that Steve withdraws $14,000 in 2009. Although he is younger than age 59½, no penalty tax applies because five years have passed since the years that Steve completed his conversions.

Roth IRA Earnings
Under the Roth IRA distribution ordering rules, earnings are the last Roth IRA assets distributed. This is significant because the featured benefit of the Roth IRA is the ability to avoid paying income tax on the earnings. A distribution of Roth IRA earnings is a qualified distribution, not subject to income tax or penalty tax, if:

The Roth IRA owner’s five-year holding period has ended, and
The distribution is for one of four qualified reasons

Five-Year Holding Period

Unlike the separate five-year period that applies to each traditional IRA conversion to a Roth IRA, a Roth IRA owner has only one five-year holding period for determining taxable Roth IRA earnings. Under Treasury Regulation Section 1.408(A)-6, Q&A-2, the five-year holding period begins January 1 of the tax year for which an individual makes his/her first regular/spousal Roth IRA contribution or in which he/she converts traditional IRA assets.

Example
Nancy made a Roth IRA contribution for 1998 on April 15, 1999, at MNO Bank. On January 15, 2002, she made another regular Roth IRA contribution for tax-year 2001 at XYZ Credit Union. Her five-year holding period for determining taxable earnings distributions from either Roth IRA began January 1, 1998, and ended after December 31, 2002.

Qualified Distributions of Earnings

A distribution of Roth IRA earnings after the end of a Roth IRA owner’s five-year holding period is qualified if the Roth IRA owner:

Has attained age 59½, or
Is disabled, or
Is taking a qualified first-time homebuyer distribution, or
The distribution is to a beneficiary after the death of a Roth IRA owner

Reporting Roth IRA Distributions
IRA custodians/trustees generally report Roth IRA distribution amounts with one of three IRS distribution codes:

Code Q—if the custodian/trustee knows that the IRA owner’s five-year holding period has expired and he/she has attained age 59½, has died, or is disabled
Code T—if the custodian/trustee does not know if the IRA owner’s five-year holding period has expired but knows that the IRA owner has attained age 59½, has died, or is disabled
Code J—if Code Q or Code T does not apply

The IRA custodian/trustee is not responsible for reporting the type of asset (regular/spousal or conversion contributions or earnings) distributed. Note: The 2005 Instructions for Forms 5498 and 1099-R indicate Codes J, T, and Q for most Roth IRA distributions. The IRS currently plans to release the 2006 reporting instructions, and the associated codes, on November 21, 2006.

A Roth IRA owner completes IRS Form 8606 for each year he/she take a Roth IRA distribution with some exceptions (see the Instructions for Form 8606). This helps determine and explain to the IRS the type of asset withdrawn and figures any taxable and penalized portion.

Simply Stated
To ensure tax-free and penalty-free Roth IRA withdrawals, a Roth IRA owner should:

Delay distributions of more than his/her regular contribution amounts until the five-year holding period expires
If younger than age 59½, wait five years from each conversion year before withdrawing converted assets
Defer distributions of earnings until attaining age 59½
Seek professional tax advice to determine the taxation of Roth IRA distributions