by Denise Appleby, APA, CISP, CRC, CRPS, CRSP
Since the Roth IRA was introduced in 1998, the Roth-versus-traditional-IRA debate has been a hot topic, with various arguments being made for one or the other. A key selling point for those who favor Roth IRAs is that the upfront cost of paying taxes on contributions when they are made will be rewarded with tax-free earnings. But Roth IRA earnings are tax-free only if they are part of a qualified distribution. For interested parties, the question becomes, “How does one know if a Roth IRA distribution is qualified?” And if the distribution isn’t qualified, “What are the tax implications?”
The following two steps can be used to help provide the answers to these questions.
Step 1: Determine if the Roth IRA distribution is qualified. A Roth IRA distribution is qualified if it meets the following two requirements:
1. It occurs at least five years after the owner first funded a Roth IRA. This funding can be with a valid regular Roth IRA contribution or a qualified rollover contribution. A qualified rollover contribution is a conversion from a traditional IRA, SEP IRA, a SIMPLE IRA—providing that the SIMPLE IRA has been funded for at least two years at the time of the conversion, or a rollover of traditional (non-Roth) amounts from an employer-sponsored retirement plan.
2. The distribution is made under any of the following circumstances:
1. The rule starts with the owner’s first Roth IRA: The five-year period for a qualified Roth IRA distribution starts January 1 of the first year that the Roth IRA owner funded any Roth IRA.
Example: John made a regular Roth IRA contribution in February 2023 for 2022. Making this contribution is the first time John funded a Roth IRA. John converted his traditional IRA to his Roth IRA in 2023. John’s five-year period for determining if he meets Five-Year Rule Number One is January 1, 2022. If John had made the regular Roth IRA contribution for 2023, his five-year period for determining if he meets Five-Year Rule Number One would have started on January 1, 2023.
2. It does not restart.
Example: Susie converted $5,000 to her Roth IRA in 2015. This conversion is her first Roth IRA funding. She withdrew the entire amount, including earnings, in 2016. She no longer has a Roth IRA at this point. Susie started a new Roth IRA in 2023. When Susie takes a distribution from this new Roth IRA, the five-year period for a qualified distribution still starts January 1, 2015, even though the 2015 Roth IRA was fully distributed and closed.
3. A beneficiary inherits a Roth IRA owner’s five-year clock. A distribution from a beneficiary Roth IRA is qualified if it meets Five-Year Rule Number One. The five-year period is inherited from the owner. Using the example of Susie above, if she dies in 2023, the five-year period for her inherited Roth IRA starts January 1, 2015. All of an individual’s Roth IRAs (not including beneficiary Roth IRAs) are aggregated and treated as one to determine if Five-Year Rule Number One is satisfied. No further assessment is needed if a Roth IRA distribution is qualified because the distribution is tax-free; there is no federal income tax, and there is no 10% additional tax (early distribution penalty). If a Roth IRA distribution is nonqualified, then Step 2 must be taken.
Step 2: Apply the ordering rules for nonqualified distributions. A Roth IRA distribution is nonqualified if it does not meet the two requirements above. The ordering rules must be used to determine what portion of a nonqualified distribution is subject to income tax and/or the 10% early distribution penalty. Under the ordering rules, distributions are taken from the following layers of sources in the order listed.
1. Layer 1 consists of regular Roth IRA contributions and rollover of basis amounts from designated Roth accounts. A designated Roth account can be a Roth 401(k), Roth 403(b), or governmental Roth 457(b) account. All an individual’s Roth IRAs (not including beneficiary Roth IRAs) are aggregated and treated as one to determine an individual’s total amount in Layer 1. Distributions from Layer 1 are tax-free.
2. Layer 2 consists of qualified rollover contributions. (See above under Step 1: Determine if the Roth IRA Distribution Is Qualified). Distributions from Layer 2 are tax-free. However, if the distribution occurs before the Roth IRA owner is at least age 59½, it is subject to a 10% early distribution penalty tax unless the distribution qualifies for an exception. One of the exceptions is Five-Year Rule Number Two. Under Five-Year Rule Number Two, the five-year period starts January 1 of the year the qualified rollover contributions are done and applies separately to each year. All of an individual’s qualified rollover contributions (not including rollovers to beneficiary Roth IRAs) are aggregated by year to determine an individual’s total amount in Layer 2.
Example: 45-year-old Tara converted $75,000 from her traditional IRA to her Roth IRA in 2018, and $25,000 from her SEP IRA to her Roth IRA in 2018. This is a total of $100,000 for 2018. Tara also converted $50,000 from her traditional IRA to her Roth IRA in 2023. The $100,000 2018 conversion will be distributed before the $50,000 2023 conversion.
Scenario 1: If Tara distributes the $100,000 in 2023, it will not be subject to the 10% early distribution penalty because it would have been at least five years since it was converted to her Roth IRA.
Scenario 2: If Tara distributes the $100,000 and the $50,000 in 2024, only the $50,000 would be subject to the 10% early distribution penalty because it would not have been at least five years since it (the $50,000) was converted to her Roth IRA. The 10% early distribution penalty would be waived if Tara qualifies for an exception. One would only get to Layer 2 once the entire amount in Layer 1 is distributed.
3. Layer 3 consists of earnings accrued in the Roth IRA and the earnings portion of a nonqualified distribution from a designated Roth account. All of an individual’s Roth IRAs (not including beneficiary Roth IRAs) are aggregated and treated as one for purposes of determining an individual’s total amount in Layer 3. One would only get to Layer 3 once the entire amount in Layer 2 is distributed. The road to tax-free Roth IRA distributions. The goal of saving in a Roth IRA is to get tax-free distributions—including no 10% early distribution penalty. If one cannot wait until one is eligible for a qualified distribution, the next best strategy is to ensure withdrawals consist only of amounts from Layer 1 as those amounts would be tax-free and penalty-free. For Layer 2, one could wait five years to avoid the 10% early distribution penalty on distributions if one is under age 59½ and does not qualify for an exception. For earnings, the only way to avoid income tax is to ensure the distribution is qualified. However, the 10% early distribution penalty can be avoided if one qualifies for an exception.
To find out if your Roth IRA distribution is taxable, please reach out to Brien or Laurie, Brien@TraditionsWealthAdvisors.com Laurie@TraditionsWealthAdvisors.com or 979-694-9100.