A Guide To Tax Treatments of Roth IRA Distributions

The Roth IRA has many benefits compared to the traditional IRA. Distributions from traditional IRAs, for example, are generally treated as ordinary income and may be subject to income tax. Distributions from traditional IRAs may also be subject to an early distribution penalty if the withdrawal occurs while the IRA owner is under the age of 59½. A Roth IRA, on the other hand, allows qualified distributions to be free from tax and penalties. The question is, which distributions are considered qualified?

Expanding on Qualified Distributions

First of all, distributions of Roth IRA assets from regular participant contributions and nontaxable conversions can be taken at any time, tax-free and penalty-free. However, distributions on taxable conversion amounts may be subject to the 10% early distribution penalty. Distributions of earnings that are part of a non-qualified distribution are taxable and may be subject to an additional 10% early-distribution penalty.

There is a distinction regarding which distributions are qualified and are thus exempt from taxes and penalties. To be qualified, a distribution must meet both of the following two categories of requirements:

1. It occurs at least five years after the Roth IRA owner established and funded their first Roth IRA.
2. It is distributed under one of the following circumstances:

• The Roth IRA holder is at least age 59½ when the distribution occurs.
• The Roth IRA holder is disabled when the distribution occurs.
• The beneficiary of the Roth IRA holder receives the assets after the owner’s death.
• The distributed assets will be used toward the purchase, building, or rebuilding of a first home for the Roth IRA holder or a qualified family member. This is limited to $10,000 per lifetime. Qualified family members include the Roth owner, their spouse, their or their spouse’s children, grandchildren, parents, or other ancestors.

For this purpose, all Roth IRAs of an individual are counted for determining the five-year period. If an individual established a Roth IRA at ABC Brokerage in 2019, for example, and established a second Roth IRA at XYZ Brokerage in 2020, the five-year period begins in 2019. The five-year period begins with the first day of the year for which the first contribution was made.

If, for instance, the first Roth IRA contribution was made for 2019, the five-year period begins Jan. 1, 2019. This is true even if the 2019 contribution is made in 2020 by the deadline of July 15, 2020.

How Non-Qualified Distributions Are Taxed

The tax implications of a non-qualified distribution depend on the source of the Roth IRA assets. There are four possible sources of Roth IRA assets:

• Regular participant contributions and rollover of basis from designated Roth accounts.
• A Roth conversion or rollover of taxable assets (pretax assets from traditional IRAs, SEP IRAs, SIMPLE IRAs, and employer plans such as qualified plans, 403(b), and governmental 457(b) plans.) These assets are taxed when converted or rolled over to the Roth IRA.
• A Roth conversion or rollover of nontaxable assets (basis amounts in traditional IRA and after-tax assets from employer plans such as qualified plans and 403(b) plans). These assets are not subject to income tax when converted to a Roth IRA.
• Earnings on all Roth IRA assets and rollover of earnings from a non-qualified distribution from a designated Roth account.

To determine the source of assets distributed from a Roth IRA, the IRS uses ordering rules. According to the ordering rules, assets are distributed from a Roth IRA in the following order (once assets from one source run out, the assets from the next source are distributed):

1. Regular Roth IRA participant contributions
2. Taxable conversion and rollover amounts
3. Nontaxable conversion and rollover amounts
4. Earnings on all Roth IRA assets

Under the ordering rules applicable to Roth IRAs, contributions are always deemed to be withdrawn first. Roth conversion amounts are not considered distributed until all contribution amounts have been distributed; earnings are not considered distributed until all contribution—and then all conversion—amounts have been distributed.

Distributions of Roth IRA assets from regular participant contributions and from nontaxable conversions of a traditional IRA can be taken at any time, tax- and penalty-free. A non-qualified distribution of taxable traditional IRA conversion assets may be subject to early distribution penalties.

Finally, a non-qualified distribution of earnings may be subject to income tax and the early-distribution penalty. The following illustration shows when taxes and the early-distribution penalty apply to non-qualified distributions.

Example of Distributions

John established his first Roth IRA in 2018 and made a participant contribution of $5,000 a year. In 2018, he converted his traditional IRA assets to his Roth IRA. In 2020, John is 55 years old and the balance in John’s Roth IRA at that time is represented as follows:

John wants to know the tax consequences should he distribute assets from his Roth IRA in 2020. Remember that assets are distributed in the following order:

• Participant contributions
• Conversions
• Earnings

We will use examples of various 2020 distribution amounts from John’s Roth IRA to show their tax treatment.

Distribution of $10,000

If John takes a distribution of $10,000, it will be tax-free and penalty-free for the following reasons:

• According to the ordering rules, John’s distribution comes from his regular participant contributions until these are used up.
• According to the regulations, the distribution of regular contributions is always tax-free and penalty-free, regardless of when the distribution occurs. There is no waiting period.

Distribution of $25,000

If John takes a distribution of $25,000, the first $10,000 comes from his regular Roth IRA contributions and is, therefore, tax-free and penalty-free. The additional $15,000, however, comes from his taxable conversion assets. Because these assets were taxed when converted, there will not be any income tax owed on the distribution.

While these assets are not subject to income tax, they are subject to the 10% early distribution penalty, unless it has been five years since the assets were converted. Unfortunately, it hasn’t been five years since John’s conversion. But the penalty may still be waived if John meets one of the exceptions, which include the following:

• He is at least age 59½ when the distribution occurs.
• John is disabled when the distribution occurs.
• John’s beneficiary distributes the assets after John’s death.
• John uses the assets for eligible medical expenses for which he was not reimbursed.
• John’s distribution is part of a SEPP program of substantially equal payments.
• John uses the assets for higher education expenses.
• John uses the assets to pay for medical insurance after losing his job.
• John’s assets are distributed as a result of an IRS levy.
• The assets are a qualified reservist distribution.
• The distribution is for qualified disaster recovery assistance.
• The amount is rolled over within 60-days, if eligible.

If John does not meet any of these or other exceptions, the additional $15,000 will be subject to a 10% early-distribution penalty.

Distribution of $70,000

Like the first $10,000 distributed in the two preceding examples, the first $10,000 here is tax-free and penalty-free. The next $50,000 will be attributed to taxable conversion assets, which will not be subject to income tax because they were taxed when converted.

However, the $50,000 is subject to the 10% early-distribution penalty unless it has been five years since the assets were converted (which is not the case in this example), or if John meets one of the exceptions, some of which are listed above under the example “Distribution of $25,000.” The additional $10,000 is attributed to nontaxable conversion assets. These will not be subject to taxes or the early-distribution penalty because no deduction was allowed when they were contributed to the traditional IRA.

Distribution of $75,000

Withdrawn amounts of up to $70,000 will be treated as in the example above. Because John has not had his Roth IRA for five years, the earnings ($5,000) will be subject to income tax. The withdrawal will also be subject to the 10% penalty unless John qualifies for an exception.

The following chart summarizes the tax treatments of the assets in John’s Roth IRA:

Each conversion has its own five-year period. For a conversion that occurs in 2020, the five-year period ends on Dec. 31, 2025.

Tax Treatment Chart

The following chart summarizes the tax treatment of all possible Roth IRA distributions:

The SECURE Act

The president signed the Setting Every Community Up for Retirement Enhancement (SECURE) Act in December 2019. This act made some changes that affect IRA accounts.

Previously, designated beneficiaries of IRA accounts were eligible to stretch distributions over their life expectancy; however, the new standard is a “10-Year Rule.” Under this new rule, the entire inherited retirement account must be emptied by the end of the tenth year following the year of inheritance. However, the following beneficiaries are excluded from this rule and the previous rules still apply:

• Spouses
• The disabled
• The chronically ill
• Individuals who are not more than 10 years younger than the decedent
• Certain minor children

Additionally, required minimum distributions (RMDs) now begin at age 72 instead of age 70½. This rule applies to those who turn 70½ in 2020 or later. Keep in mind that there are no RMDs for Roth IRAs. The increase in age for RMDs could allow a retiree more time before converting to a Roth IRA—if that’s their strategy. The SECURE Act also did away with stretch IRAs for traditional and Roth IRAs.

The act also introduces a new exception to the 10% early distribution penalty. Up to $5,000 can be distributed penalty-free from an IRA or from a plan as a “Qualified Birth or Adoption Distribution.”

Lastly, account holders can contribute to traditional IRAs beyond age 70½, which was not the case before the SECURE Act was signed into law.

Changes Due to COVID-19

The CARES Act, which was signed into law by former President Trump in March 2020, suspended certain rules governing retirement accounts that are designed to help Americans survive the coronavirus crisis.

You are not required to take RMDs for the calendar year 2020, which means you don’t have to sell investments that may have dropped in value. And if you have been harmed by the pandemic—you tested positive for the virus, for example, or you and your spouse lost your jobs—you can withdraw up to $100,000 from your retirement account without incurring the 10% penalty. You’ll be able to pay any taxes you might owe over a three-year time span from the date you withdrew the money, and you’ll be allowed to return the money to your account within the same period.

Without RMDs in 2020, retirees could have converted a traditional IRA to a Roth IRA if they turned 72 that year and avoided RMDs.

The Bottom Line

If an IRA holder completes multiple Roth conversions, the five-year period is determined separately for each conversion. For determining qualified distributions, there is only one five-year period; it 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 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.

Just because you can distribute your retirement assets before you reach retirement age doesn’t mean you should. Individual taxpayers must seek competent professional assistance to ensure it’s a good idea and that the Roth IRA transactions are handled properly.