Qualified Roth distribution for first time home

Submitted by BruceM on Thu, 2009-04-02 22:22

Must one have held a Roth at least 5 years to be eligible for a qualified distribution to purchase a first time home?

For example, Joe at age 22 contributes $4,000 to his Roth from part time job earnings (that were >$4,000). At 23 he does a TIRA conversion to his Roth of $2,000. The value of the Roth at age 25 is $9,500 and he wants to use it as a down payment on his first home (principal residence). Would this full withdrawal be considered ‘qualified’ for purposes of purching the home, or would he have to wait until age 27 (the 5th year after funding his first Roth), and would the conversion make any difference?

Thanks

BruceM



Submitted by mk foss on Thu, 2009-04-02 22:46

There is no time limit for using the first time homebuyer feature of the Roth IRA law. Any amount that would normally be taxable vecause it comes out in the first five years is not taxable if used for a first time home purchase. Also there is no 10% penalty.



Submitted by Clyde Wolf on Thu, 2009-04-02 23:18

Mgt4cpa,

You state, “[i]Any amount that would normally be taxable vecause it comes out in the first five years is not taxable if used for a first time home purchase.”[/i]

Is this new? The ROTH IRA owner’s basis including the converted amount would not be taxable, but wouldn’t any gains be taxable?

I agree the 10% early distribution penalty would be waived.



Submitted by mk foss on Fri, 2009-04-03 02:47

For a regular IRA $10k can be withdrawn without a 10% penalty. With a Roth $10k of earnings can be withdrawn, using the Roth for a first time home purchsae allows a larger withdrawal. Looking back at my source material I did err in that explanation. A qualified (income tax free distriubtion) is made after the five-year period plus meets the requirements for a first home withdrawal.

I shouldn’t have responded so quickly.



Submitted by Alan Spross on Fri, 2009-04-03 04:07

Bruce,
As indicated, without the 5 year Roth holding period being met, a qualified first home purchase still does not produce a qualified Roth distribution, and the ordering rules apply to taxation of the distribution.

Therefore, in your example, the earnings of 3,500 would be taxable. These expenses would NOT be entered on line 20 of Form 8606 because the 5 year holding period for the Roth has not been met. However, the first home exception still provides the benefit of waiving the early withdrawal penalty on not only the conversion distributions that did not meet the conversion holding requirement, but also on the earnings. Bottom line, the only cost is ordinary income tax on the 3,500.

Using the same example, but after the 5 year holding period of the Roth has been met, all taxation and penalties are eliminated as the distribution is considered qualified. However, you still must complete Form 8606, lines 19-21 in this case, whereas you do not for other types of qualified distributions. If someone had a Roth balance of 60,000 and 10,000 of this were earnings, a qualified 10,000 first home distribution after the Roth 5 year holding had been met would come totally from the earnings. The taxpayer would then have 50,000 left in the Roth, all of which would be basis from contributions. Pub 590 does not really explain any of this clearly.



Submitted by BruceM on Fri, 2009-04-03 17:03

Alan
Yes, this is what I had reasoned, but thought I’d ask first.
The one point you raised I had no idea of was the $10,000 withdrawan from a larger RIRA for a first time home would come entirely out of earnings! Good to know!

As usual, thanks again

BruceM



Submitted by Clyde Wolf on Sat, 2009-04-04 01:42

Mgtf4cpa, and Alan-oniras,

Thanks for your clarifications and insights.



Submitted by Edward Czapor on Mon, 2009-07-20 23:46

Alan,

Your response that a qualified distribution would come entirely from earnings also surprised me, and has been in the back of my mind since the original post. I recently reviewed IRC 408A and Treas. Reg. 1.408A and find nothing to that effect. Have I missed or misenterpreted something or is there another source. I checked to see how my professional tax software would handle your last example, and the ordering rules are still applied, with earnings not distributed first. The software always applies the ordering rules with various scenarios, whether distributions are qualified or not. Now I question whether the software is in error. Of course Roth basis and ordering rules can be ignored after age 591/2 and 5 year establishment (at least currently). Can you provide any additional information or clarification?

Thanks in advance,

Ed C.



Submitted by Alan Spross on Tue, 2009-07-21 01:41

Ed,
You are correct that that the Regs are incomplete with respect to accounting for the qualified part of a first home distribution. They are clear that the ordering rules do NOT apply to qualified distributions, just to non qualified distributions. The first home distribution is identified in the tax code as a “special purpose distribution”. This happens to be the only situation where you can have a qualified distribution or partially qualified distribution and then have to return to the ordering rules because the entire Roth is not yet qualified.

To cut to the chase, the only way I firmed up this conclusion was doing a test case on Form 8606, Part III. Effectively, the 8606 starts with the gross distribution on line 19 and then backs out the qualified first home portion on line 20. Note that the first home distribution cannot go on line 20 unless the Roth has met the 5 year holding requirement per the 8606 instructions. More confusion results from the fact that a qualified first home purchase from Roth funds is NOT a qualified Roth distribution unless the 5 year holding period is met. This is clear from Pub 590. Returning to Form 8606 for tax purposes, the taxation of this distribution subject to ordering rules only addresses the amount left after the qualified first home part has been backed out. My conclusion mainly rests on the Inst for line 22 when you enter your remaining basis. The 8606 instructions do not reduce your remaining basis in either regular or conversion contributions by amounts distributed as qualified distributions, ie qualified first home amounts. If your remaining balance in these amounts remains unchanged, it can only mean that the qualified amount came out of earnings.

Another point to be made is that the first home purchase exception appears twice in Pub 590, once to determine whether a Roth distribution is qualified, and separately to clarify that IF the distribution is not qualified (no 5 year holding met), the exception will still waive the early withdrawal penalty on the taxable part. Therefore you end up with the following two general scenarios:
1) First home purchase comes out of a Roth not yet held 5 years. Result is that is is NOT qualified, the ordering rules apply to the entire amount, AND if 5 year conversion or earnings are tapped, there is no early withdrawal penalty. The only tax would be ordinary income tax on any earnings.
2) Same purchase except that the Roth meets the 5 year holding period and the first home portion is therefore qualified. The early withdrawal is waived as in above example, but there is no advantage otherwise UNLESS taxpayer has earnings in his account.

Assume example 2 above but taxpayer has NO earnings, probably a common situation after the market meltdown. There is still a qualified distribution, but no earnings to become tax free. But there is still an advantage here because the taxpayer’s remaining balance is regular or conversion contributions remains unreduced to be used later if necessary for tax free return of contributions. Actually, to do it any other way would render the first home exception worthless other than for early withdrawal waiver.

There actually could be a two fold problem here with tax software. Not only must it get the 8606 correct for the taxable amount, but it also must allocate the remaining Roth between contributions and earnings. It might get the 8606 correct and still excessively reduce the basis remaining in the Roth.



Submitted by Alan Spross on Tue, 2009-07-21 05:04

Ed,
Looking into this situation, I think I have located an error in the 8606 Inst. It would not affect the tax treatment of a qualified first home distribution in the year of the distribution, but the instructions for determining the basis remaining in subsequent years seems to be incorrect. If the first home comes out of earnings, then the remaining basis for following years should not be reduced. If it is, the benefit of a tax free earnings distribution is recaptured in later years. This cannot be correct.



Submitted by Edward Czapor on Tue, 2009-07-21 23:44

Alan,
Thanks for your response and sharing your thought process on how you arrived at your conclusion regarding earnings coming out first in a qualified distribution. I do not agree with this conclusion, and will try to explain my logic. My conclusion is reached from information in Treas. Reg. 1.408A-6, and I believe confirmed by A-4 in this Reg.
I do agree that the Regs are clear that the ordering rules do not apply to qualified distributions, just to non qualified distributions. However I interpret this to mean that they apply to calculate tax and possible penalty for non qualified distributions. They do not apply to qualified distributions for tax or penalty since by definition there is none. I do not believe the non application extends to the determination of basis for a qualified distribution.

In your test case on Form 8606 Part III, after the qualifying distribution is backed out, the basis on line 22 is needed to calculate tax on any excess from line 19 over basis on the non qualified portion of the distribution. The basis is not applied to to the qualified portion for tax purposes, but does not necessarily mean that it does not affect the basis remaining in the qualified distribution. The reality is that the first time home buyer exception can be worthless except for the early withdrawal penalty. There is no rule that tax rules need to make sense.

Treas. Reg. 1.408A-6 example 7 for a qualified distribution refers to example 6 where the ordering rules for distributions are followed. If everything is the same as stated for example 7, then the ordering rules must also be followed in example 7. I believe this is confirmed in A-4 for non qualified distributions. The key here is in the wording (whether or not they were qualified distributions). To me this means that basis in qualified distributions must be included. For example if you had a non qualified distribution of 10,000 after a qualifying first time home buyer distribution you would end up with a taxable distribution of 10,000. 10,000 current distribution plus previous qualified 10,000 (not reduced since none was taxed), 20,000 – 10,000 = 10,000 taxable. If you assumed the qualified distribution came from earnings, the tax would be zero, and would not comply with A-4.

Bottom line – The ordering rules are applied to non qualified distributions for calculating tax and penalty. Ordering rules are not applied to qualifying distributions for tax or penalty since there are none. Ordering rules are still applied to all distributions including qualifying to track remaining basis. Does this make sense, or am I way off base.

Ed C.



Submitted by Edward Czapor on Wed, 2009-07-22 02:09

Forgot to add the example had an original contribution basis of 10,000.



Submitted by Alan Spross on Wed, 2009-07-22 04:36

Ed,
I agree with you that A-4 appears to be the key regulation determining the affect of a qualified first home distribution on later Roth distributions, and that the earnings in the Roth are ONLY erased tax free if you drain the account in the year of the first home distribution. This is the only scenario I tested out, and incorrectly assumed that it would also be valid for the life of the Roth. Not so, as you pointed out.

But take a look at the 8606 Inst for line 22. A Roth distribution taken the same year as the first home distribution or if the first home distribution is partly qualified and partly NQ, the Inst say to enter your regular contribution basis on line 22. So if you close the Roth that year, the earnings get out tax free.

But once the year of the first home distribution has passed, the the 8606 Inst per the chart on p 8 indicate to enter on line 22 from the prior year 8606 the excess of line 22 over 19. Since 19 includes the qualified first home amount, the excess amount on line 22 over 19 is reduced. Reducing 22 equals a reduced basis. So here we have recapture of the prior first home distribution where it now comes out of your basis, inflicting a sort of retroactive ordering rule on the first home distribution. So A-4 appears to agree with this scenario, but not with the current year scenario. Do you follow this?

No dang wonder we never see a capsulized summary of the future affect of a first home distribution on the Roth basis. The only other situation I can think of where a Roth would produce a qualified distribution followed by a NQ distribution would be a disability followed by an unexpected recovery from the disability. But I think the effect would be the same there.



Add new comment

Log in or register to post comments