Roth IRA distribution rules
are multifaceted, and can seem a bit complicated. However, they do follow an order based on the source of funds for each distribution. The source of funds determine how each distribution type is taxed.
Below is a fictional situation that brings into play the different types of Roth distributions and the IRS rules that govern them. The potential tax consequences of each distribution type is analyzed and identified. Use the following situation to simplify and understand the order of Roth IRA distributions.
Mrs. Hibbard turned 61 in 2015. She owns a Roth IRA with a balance of $20,000. Her Roth IRA was established in 2012. Initially she made a $4,000 contribution, converted $10,000 from a Traditional IRA, and rolled over $2,000 from a Roth 401(k).
Mrs. Hibbard paid taxes in 2012 on the conversation amount of $10,000, but not on the rollover amount, as it was a non-taxable event. Mrs. Hibbard wants to distribute the entire balance of $20,000 and close the account. What are the tax consequences of doing so?
First, Mrs. Hibbard must find the Source of Funds and determine the order of distribution. In this case, the order would appear as follows:
- Contribution - $4,000
- Taxable Conversion - $10,000
- Non-Taxable Rollover - $2,000
- Earnings - $4,000
Now that we know the order, we need to know if the distributions are qualified or not to determine the tax consequences.
A Roth distribution is qualified
if it meets following criteria:
- The distribution was made after a 5 year period, beginning with the first taxable year a Roth contribution was made, and
- The payment or distribution was either:
- Made after 59 ½ years of age, or
- Made because of disability, or
- Made to beneficiary because of death, or
- One that meets the requirements under first home exception.
Was Mrs. Hibbard’s distribution qualified? Because the five year waiting period as described in 1) above has not been satisfied, the answer is no. Therefore, the entire amount withdrawn will be considered a non-qualified distribution..
The first of the funds to be distributed are the contributions
– there are no additional tax consequences for making a non-qualified distribution of regular Roth IRA contributions. Contributions can be returned at anytime. So the tax consequence of Mrs. Hibbard distributing her initial contribution amount would be nothing.Taxable conversions
are the next source of funds to be distributed. We’ve already determined that the distribution is non-qualified because of the five year rule. However, conversions and rollovers have an additional five year rules that start the year of the conversion or rollover. Since the conversion occurred in 2012 and the distribution is occurring in 2015, the five year period for the conversion has not been satisfied, and would therefore normally be subject to the 10% early withdrawal penalty.
However, because Mrs. Hibbard is over the age of 59 ½, she is entitled to the exception to the 10% early withdrawal penalty that would normally be assessed. Because taxes were already paid on the conversion, this amount is not subject to ordinary income tax either. Once again, the tax consequence to distributing her conversion amounts would be nothing.Non-Taxable Rollover
is next in line to be distributed. Because Mrs. Hibbard rolled over $2,000 from a Roth 401(k) into another Roth account after she was 59 ½, the tax consequence for the rollover is nothing.Earnings
is the last source of funds to be distributed. Because Mrs. Hibbard is over 59 ½, she can take distributions of her account earnings without accruing the 10% additional tax for early withdrawal. Mrs. Hibbard does not have to pay any additional taxes for the distribution of her entire account balance.
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