Roth Distributions

Submitted by David Benson on Tue, 2008-06-17 18:32

I am having trouble understanding the differences between the rules for “additional tax on early distribution” and “qualified distribution” as they relate to a Roth IRA. In Pub 590 it looks like both the “additional tax on early distribution” rules and the “qualified distribution” rules are independent of each other and I have to meet them both for any distribution.

I have a Roth funded only with conversion contributions and do not need to pay the 10% additional tax on early distribution of conversion contributions because I meet one of the exceptions – I am older than 59 1/2.

There were no regular contributions to this Roth, only conversion contributions, so I must consider the “qualified distribution” rules. In Pub 590, when a Roth IRA has been funded only with conversion contributions, there is a 5-year waiting period plus one of four additional conditions which must be met for any distribution to be a “qualified distribution”. The first contribution to this Roth IRA was a conversion contribution when the IRA was set up in November 2005.

1. Is there only one 5-year “qualified distribution” waiting period even though conversions were made in 2005, 2006 and 2007?

2. Does this waiting period begin January 1, 2005 and run through December 31, 2009?

3. Is there anything that exempts my conversion contributions from the qualified distribution rules?

Thank you



Submitted by Edward Czapor on Tue, 2008-06-17 21:28

1. Yes there is only one 5 year holding period for a qualified distribution, (not taxed or penalized) and it must be met without exception. This holding period starts with the first year a Roth is established. It does not matter whether a Roth is established by contribution or conversion.

2. Yes

3. No, there is no distinction between contributions or conversions for the 5 year holding period for qualified distributions.

Any distributions prior to Jan. 1, 2010 would still be tax and penalty free umless you withdrew earnings which would be taxed but not penalized. Under the ordering rules, the converted amounts are deemed withdrawn before earnings.

Ed C.



Submitted by David Benson on Wed, 2008-06-18 01:21

Ed, thanks for your reply, but I am still confused.

Perhaps I don’t understand the terminology. There is a holding period which ends Dec 31, 2009 before distributions are tax free, that is, not included in gross income. Doesn’t this include distribution of my conversion contributions?

Yet in your last paragraph any distributions prior to Jan 1, 2010 would be tax free. Aren’t distributions of conversion contributions taken before Jan 1, 2010 taxable because they are not yet qualified?



Submitted by Alan Spross on Wed, 2008-06-18 01:35

No, Ed is correct.

Distribution of conversions are always tax free because you paid tax on them for the year of the conversion. This is true regardless of age even though distributions are not technically qualified until the 5 year holding period is satisfied,

In your case, since you are over 59.5, there is also no penalty on those conversion distributions.

Your distributions become fully qualified for tax free treatment as of 1/1/2010, and if your IRA custodian is aware of your holding period (they know your age), they will code your distributions with a “Q” for qualified. That means you do not even need an 8606 to report them. Just enter then on line 15a of Form 1040 only.



Submitted by Edward Czapor on Wed, 2008-06-18 22:06

I belive there is unnecessary concern over Roth taxation. In reality there are likely few Roth withdrawals actually taxed due to the ordering rules with the exception of cashed out accounts. What many fail to comprehend is that the only part of a Roth ever taxed are earnings. Earnings are also the only part penalized with the exception of converted amounts. With converted amounts, the penalty is not about a Roth, but the penalty that would be paid anyway on withdrawal from a TIRA, and even this will disappear after 5 years.

Since the funds in a Roth are largely accessible, I advise clients to think of it as a tax free account rather than an IRA, that can be used as an emergency fund. Of course withdrawals should be avoided if possible since they are difficult to replace due to contribution restraints and conversion taxation.

Ed C.



Submitted by David Benson on Fri, 2008-06-20 01:45

Sorry to keep pushing this issue but I am trying to put together instructions and information for my wife in the event of my untimely death. I have pondered Alan and Ed’s responses and studied Pub 590 some more and I think I have my answers.

In chapter 2 of IRS Pub 590 under the heading “Are Distributions Taxable?” we find that qualified distributions or distributions that are a return of your regular contributions are not included in gross income. Roth to Roth rollovers are also not included in gross income. Question 1 – Doesn’t this mean that all other distributions, including conversion contribution and earnings distributions, are included in gross income until they become qualified distributions?

I have distilled my situation down to items A and B below. Question 2 – Are A and B correct? Keep in mind that my Roth IRAs include only conversion contributions and earnings.

A. After the 5-year qualified distribution waiting period ends, distributions of conversion contributions and earnings to an owner older than 59 1/2 or to beneficiaries would be qualified distributions and neither taxable nor subject to the 10% additional early distribution tax.

B. If taken before the 5-year period ends, distributions of conversion contributions and earnings to an owner older than 59 1/2 or to beneficiaries would be included in gross taxable income but not subject to the 10% additional early distribution tax.

Taxes were paid on the conversion contributions in the year of the conversion and it doesn’t seem right to include distributions of conversion contributions in gross income a second time just because they are withdrawn before five years have passed; but that is what Pub 590 seems to be saying.

Thanks for all your help



Submitted by Edward Czapor on Fri, 2008-06-20 03:49

I understand your confusion since the Pub. 590 explanation is not clearcut.
Return of your regular contributions also means conversion contributions.
This is because conversion contributions are the same as other contributions for the 5 year holding period that relates to taxation of earnings. Conversions differ only for the other 5 year rule pertaining to the 10% penalty.

A. Correct

B. Not correct – The conversion contribution would not be included in gross income. It never is under any circumstance because tax has already been paid. The earnings would be included in gross income because a Roth was not established for 5 years, but not subject to penalty.

Only earnings are ever taxed and can also be subject to penalties. Conversion contributions are never taxed, but may be penalized.

Hope this helps.



Submitted by Edward Czapor on Fri, 2008-06-20 04:10

In addition: If you look at the example on Pg. 67 of Pub. 590, “The next $3,000 of the distribution is not includible in income because it was included previously.” This is part of the conversion contribution.



Submitted by David Benson on Sat, 2008-06-21 23:28

Ref example on page 67 of Pub 590 – This would be a really conclusive example if Justin had taken his distribution before his 5-year qualified distribution waiting period had ended. The distribution, which was taken Nov 7, 2007, was taken after his 5-year qualified distribution waiting period ended on December 31, 2006. The $3000 is also a qualified distribution which excludes it from gross income.

Also to be noted in the same Ordering Rules section of Pub 590 is that there are conversion contributions and there are regular contributions – conversion contributions are treated differently than regular contributions. I remain puzzled why regular and conversion contributions, which are differentiated in the Ordering Rules section of Pub 590, aren’t differentiated in the other sections as well, and why the use of “regular contributions” in the “Are Distributions Taxable?” section doesn’t mean just that – regular contributions.



Submitted by Alan Spross on Sun, 2008-06-22 00:23

The Justin example is conclusive. Note that the distribution is not a qualified distribution because there is no mention of him being 59.5. The 5 year holding period for Roth accounts is only one of two requirements for distributions to be qualified. Since this one is NOT qualified, the ordering rules apply. Nothing is taxable, and since he has met the 5 year conversion holding requirement, there is no penalty on the 3,000 of conversions distributed.

In addition, the worksheet on p 68 also generates the same conclusion. When all contributions of any type are entered on line 12, if they cover the current distribution, there is nothing taxable on line 16.

But I agree that Pub 590 is poorly worded on p 65, “Are Distributions Taxable?” I can only guess that there was no reference to conversions there because many conversion distributions are subject to early withdrawal. Remember that early withdrawal penalty on non taxable distributions is unique to Roth conversions.



Submitted by David Benson on Sun, 2008-06-22 01:55

Justin is age 60 at the time of the distribution.



Submitted by Alan Spross on Sun, 2008-06-22 03:44

Nice catch. I missed that.

The reason I missed that arose from the assumption that the example was correct. Bad assumption, because the example is not correct. In fact, the ordering rules do NOT apply to this distribution because it is a qualified distribution. It is qualified because BOTH the 5 year and age requirements had been met by 11/7/07. Note the first sentence on p 67 that states the ordering rules apply for distributions that are NOT qualified distributions.

Since the ordering rules do not apply to this distribution, it is totally immaterial what the $7,000 was composed of. Therefore, the “Justin” example does not illustrate anything discussed previously and worse, seems to overlook that this distribution was qualified.

When a qualified distribution is reported by the IRA custodian with a “Q” Coding in Box 7, Form 8606 does not need to be completed per the 8606 Instructions.

Given the amount of misleading and erroneous statements in Pub 590, no wonder you ended up with the conclusions you have. Curious about this example, I checked prior editions of Pub 590, and this example was in both the 05 and 06 editions as well. That means nobody caught this.

Not exactly sure how this relates to your original concerns. But given the problems with Pub 590 in this area, it is appropriate to refer to the actual IRS Regs. The following is copied from the Regs:
>>>>>>>>>>>>>>>
Q–4. How is a distribution from a Roth IRA taxed if it is not a qualified distribution?

A–4. A distribution that is not a qualified distribution, and is neither contributed to another Roth IRA in a qualified rollover contribution nor constitutes a corrective distribution, is includible in the owner’s gross income to the extent that the amount of the distribution, when added to the amount of all prior distributions from the owner’s Roth IRAs (whether or not they were qualified distributions) and reduced by the amount of those prior distributions previously includible in gross income, exceeds the owner’s contributions to all his or her Roth IRAs. For purposes of this A–4, any amount distributed as a corrective distribution is treated as if it was never contributed.

>>>>>>>> >>>>>>>>>>
Worksheet 2-3 follows the above explanation.



Submitted by Edward Czapor on Mon, 2008-06-23 00:24

Alan,
Although the Justin example is a poor one, I believe it is still correct. The statements relating to the distribution and reasons for not including in income are correct. My reasoning is that a qualifying distribution qualifies earnings from being taxed or penalized. The two types of distributions in this example are not included in income, not because this is a qualifying distribution, but because they are a return of contributions/conversions or Roth basis. Yes, the example should have made Justin under the age of 591/2 and the result would have been the same. A more comprehensive example would also have put the holding period for the conversion under 5 years to illustrate a penalty on the conversion withdrawn.

Since the example is a qualifying distribution, it makes no difference as to the source of the distribution as you point out. The example does however imply that the ordering rules still apply to qualifying distributions.
The type of funds left in a Roth from which all distributions should be qualifying may still be pertinent in case of future law changes relating to Roths. Any thoughts?

Ed C.



Submitted by Alan Spross on Mon, 2008-06-23 00:40

Ed,
Yes, the tax result of the example is the same correct result, but as you indicated, the example infers that the ordering rules are still applicable after qualification. And there is no way a Roth can become “unqualified” after it first becomes fully qualified. One possible exception is the complete distribution of all Roths, and starting again. I am not aware of any ruling on whether the 5 year holding requirement must also start again or whether the year of the first contribution remains even if there are intervening years with no Roth balance.

With respect to future restrictive legislation on Roth accounts, anything remains possible, although I think any future restrictions would have to grandfather qualified Roth balances.



Submitted by David Benson on Mon, 2008-06-23 01:47

Are the actual IRA regulations available on the internet? If they are, can you please tell me how to access them?

Thank you



Add new comment

Log in or register to post comments