of Roth IRA Distributions
This material assumes that you have already made the decision to establish a Roth IRA. The confusing and difficult rules and definitions for working with the Roth IRA are covered in detail here. If you are only considering establishing a Roth IRA, you will find eligibility requirements, related definitions and other factors influencing your decision under Choosing Between a Roth IRA and Regular IRA helpful. The IRA Analyzer can help you decide which IRA is best for you and if you decide to convert, the amount of funds you will need to pay all taxes associated with the conversion.
Taxation and Penalties for Roth IRA Distributions
Qualified distributions from a Roth IRA are not includible in income or subject to the 10% early withdrawal penalty. A qualified distribution is a distribution to an owner after the owner has reached age 59½ (or who is disabled, a first-time home buyer, or in the case of a beneficiary of the estate, death) and the Roth IRA has been funded for a 5-year period, beginning on the first day of the tax year in which a conversion from a regular IRA is made or for which a contribution is made, and ending with the last day of the 5th year from the beginning year . If the distribution is made to a beneficiary of the estate of the owner, the period held by the decedent is included in the period held by the beneficiary to determine whether the 5-year period is satisfied (408A(d)(2)(A) and Reg. §1.408A-6, Q&A-1(b)).
A withdrawal from a Roth IRA is treated as made first from direct contributions to the
Roth IRA, then from conversion contributions (first-in first-out, or FIFO, basis),
and then from earnings in the Roth IRA in the order specified below under Nonqualified
Holding Periods. Each Roth owner has only one
5-year period for purposes of determining qualified distributions (Reg. §1.408A-6,
Q&A-2). An individual's 5-year period begins with the first tax year for which a
contribution is made for any Roth IRA (408A(d)(2)(B))). A conversion of a regular IRA into
a Roth IRA after the five-year period has begun will not start the running of a new 5-year
period for purposes of determining whether the distribution is a qualified
distribution (S Rept No 105-174 (P.L. 105-206, i.e, the '98 Act). Thus, once a
holding period is begun, either by a conversion or direct contribution, any distribution,
even one from contributions or conversions made before the end of the 5-year period, will
be excludable from income as a qualified distribution if the taxpayer is age 59½ or
otherwise satisfies one of the early distribution conditions (disability, death, or
qualified special purposes). One exception applies when a beneficiary inherits a
Roth IRA; the holding period for that inherited Roth IRA includes the period that the Roth
IRA was held by the decedent is added to the period held by the beneficiary. The holding
period for an inherited Roth IRA is determined independently of any Roth IRAs held
in the beneficiary's name alone (Reg. §1.408-6, Q&Q-7(b)). Caution:
Conversion contributions have their own rules for holding periods for purposes of the
Section 72(t) 10% penalty tax on early distributions from IRAs. Each conversion has
its own holding period for purposes of assessing the Section 72(t) penalty (Reg.
Penalties: If the distribution is a qualified
distribution, i.e., both the distribution conditions (age 59½, disability, death, or
special purpose) and 5-year holding period for the conversion are met, no penalty is
assessed because it is a qualified distribution. If the distribution conditions are
met, but not the 5-year holding period, no penalty will be assessed because each of the
distribution conditions are exceptions to the Section 72(t) penalty tax, although the
distribution may be taxable (Reg. §1.408A-6,Q&A-5(b)). If the distribution
conditions are not met, and any part of the distribution is allocable to any conversion
made within 5-years of any distribution, the Section 72(t) tax will be assessed as if
all of the allocable conversion were currently includible in income (408A(d)(3)(F)(ii)).
That is, the penalty tax is applied to the portion previously taxed at the time of the
rollover (the deductible portion of the regular IRA and accumulated earnings in the
regular IRA) even though it is not currently taxable upon distribution, as well as the
Roth IRA earnings (408A(d)(3)(F)(i)). The tax is not applied to basis (nontaxable portion
of the regular IRA). If the distribution conditions are not met, but the 5-year holding
period for the allocable conversion is met, the 10% penalty is assessed only against the
portion of the distribution includible in income (i.e., the earnings of the Roth IRA)
(Reg. §1.408A-6,Q&A-5(a)). Form 5329 is used to report the penalty.
Nonqualified distributions are taxable to the extent the amount of the distributions, added to all prior distributions less prior amounts that were includible in income, exceed the direct Roth contributions.
The ordering rules of the deemed sources of the distribution and their taxability are as follows:
The early withdrawals attributable to the nondeductible portion of a regular IRA (item 3) are not subject to the 10% early withdrawal penalty-see Penalties above.
The exceptions under Code Section 72(t) to the 10% additional tax on premature
withdrawals (e.g. for individuals who have reached age 59½) apply to nonqualified
distributions within the five tax year period from, and attributable to, conversion
contributions. For instance, an owner who has reached age 59½ may make
distributions before attaining the 5-year period without penalty, although the
distribution may be subject to tax.
A taxpayer makes contributions as follows: a direct contribution of $2000 each year for 5 years and a rollover in the second year of $80,000, of which $60,000 is immediately taxable because it is attributable to deductible contributions and earnings at the time of the rollover. After 5 years from the beginning of the year of the original direct contribution, a total distribution is made when the Roth IRA had a value of $85,000, $5,000 less than the taxpayer's basis. The taxpayer is not over age 59½ and does not meet any of the other qualifying conditions under Section 72(t). The tax consequences are as follows:
Because it was a total distribution, the taxpayer may deduct a loss in the final
year for the remaining basis as with other IRAs (Notice 87-16, 1987-1 CB 446 as clarified
by Notice 89-25, 1989-1 CB 662, Q&A-7).
Aggregation Rules. For determining taxation of distributions certain Ordering and Aggregation rules apply.
All direct contributions for all years are aggregated (Reg. §1.408A-6, Q&A-9(b)).
All previous distributions, contributions, conversions must be known to determine how much remains of each category to correctly compute the taxation and penalties for the distribution.
For purposes of the 5-year holding period for determining a qualified distribution, the
holding period begins the earlier of the period determined by the rollover or the tax year
for which a direct contribution is made. (See the 1998 Restructuring Act below.)
Updates - New Laws, Proposed Regulations, and Effective Dates, Etc.
Updates - Current Law
Taxpayers with Modified Adjusted Gross Incomes not exceeding $100,000 can convert a traditional IRA to a Roth IRA, providing the funds are included in income. Financial planners have been selling annuities to traditional IRA owners and telling them that upon conversion, only the cash surrender value (CSV) is taxable. Shortly after the annuity contract is purchased by the non-Roth IRA, the taxpayer converts the IRA to a Roth IRA.. These were often marketed as "springing" annuities because the annuity value would "spring" back to full fair market value after a short time because the penalties associated with early conversion or redemption reducing the fair market value were not likely to ever be assessed. Now, in Temp. Reg. 25.2512-6, taxpayers must report the full fair market value as income upon conversion. Rev. Proc. 2006-13, 2006-3 I. R. B. 315 (12/27/05) provides a safe harbors for determining fair market value under various situations for annuity conversions.
Charitable contributions (up to $100,000) can be made directly from a traditional IRA if the owner is over 70 1/2 at the end of the tax year without including the IRA distribution in income. Taxpayers will not be able to deduct the gift. The major advantage is that all limitations based upon AGI will not be affected, such as the amount of social security taxed, phase outs of personal exemptions, etc. (Also applies to 2007).
The catch-up contribution to either type of IRA is $1000 for individuals 50 and older. The base amount is $4000 in 2006 (and 2007).
HRS, HSA Employees with a health flexible spending account (FSA) or a health reimbursement account (FRA) will be able to to make a one-time transfer of the lesser of the balances in these accounts on September 21, 2006, or the actual balance at transfer to an IRA. The election is irrevocable.
Non-spouse Rollover. A non-spouse beneficiary can now roll over benefits from a plan to an IRA so that the IRA rather than the plan can satisfy the minimum required distributions rules due the beneficiary.
Spouse and Dependent Hardship Withdrawals. Participants will be entitled to hardship withdrawals for hardships experienced by by a spouse or dependent beneficiaries if the hardship would qualify for a hardship distribution if experienced by the participant.
The base contribution is scheduled to increase to $5,000 and the catch-up will be $1000.
Beginning in 2010, the $100,000 Modified Gross Income limitation is removed and amounts converted from a traditional to Roth IRA will be taxed ratably over 2 years, 2011 and 2012. Note that under current tax law rates are extended only to 2010. So one may face higher rates.
Prior Years Laws
Proposed regulations issued in September, 1998 provide detailed thinking of the IRS on Roth IRAs. These are published as Proposed Regulations Sections 1.408A-0 through 1.408A-9. Although proposed regulations do not have the force of the law detailed below, they indicate how the IRS will rule on private letter rulings or on audit. The actual Code changes enacted in the new IRS Restructuring and Reform Act of 1998 are detailed below. Changes affecting the comments about choosing a Roth or regular IRA already reflect relevant changes in the law. The changes below primarily are additional information that may or may not influence your decision, but may provide help for tax planning.
Notice 98-50 supplements the proposed regulation for 1998 and 1999. A taxpayer who converts an amount from a traditional IRA to a Roth IRA during 1999, which amount has not been converted previously from a regular IRA to a Roth IRA, and then transfers that amount back to a traditional IRA by means of a recharacterization, is eligible to reconvert that amount to a Roth IRA once (but not more than once) on or before December 31, 1999.
Announcement 99-104 (Internal Revenue News Release 1999-78, 10-14-99) extended the deadline to the end of 1999 (from the previous deadline of October 15, 1999) to change otherwise valid recharacterizations of 1998 Roth conversions. A taxpayer will be deemed to have made a timely recharacterization back to a regular IRA (of either an ineligible contribution or conversion) if 1) the recharacterization occurs on or before December 31, 1999, 2) the taxpayer filed a timely 1998 return, and 3) the taxpayer timely files an amended 1998 return if the recharacterization was not properly reflected on the original return.
Recharacterizations and Reconversions Deadlines for tax Years after 1999. Effective January 1, 2000, an IRA owner who converts an amount from a regular IRA to a Roth IRA during any tax year and then transfers that amount back to a regular IRA by means of a recharacterization may not reconvert that amount from the regular IRA to a Roth IRA before the beginning of the tax year following the year of conversion, or if later, 30 days after the the owner transfers the amount back to the regular IRA (Reg. §1.408A-5, Q&A-9(9)(a)(1)). This is the rule that was delayed by Announcement 99-104 and Notice 98-50 above. See Examples under Recharacterizations and Reconversions below.
Notice 2000-39 (2000-30 I.R.B. 132) provides a new and more exact method of determining the earnings which must be withdrawn as a result of a contribution made after 1999 due to a recharacterization (408A(d)(6)) or corrective (returned) contributions (408(d)(4)). The actual earnings or losses of the IRA are calculated by allocating to the contribution to be withdrawn, a pro-rata portion of the earnings accrued during the period the IRA held the contribution. Under the new method net income may be negative unlike the previous method. The income or loss is transferred to the recharacterized IRA as income or reported on the return if a returned contribution. The net income includes the change in market value of the IRA during the period the contribution was in the IRA. The following formula calculates the net income (loss):
Net Income = Contribution x (Adjusted Closing Balance - Adjusted Opening Balance)/Adjusted Opening Balance.
The "adjusted opening balance" is the fair market value of the IRA at the beginning of the computation period plus the amount of any contributions made to the IRA during the computation period (including the contribution that is distributed as a returned contribution pursuant to section 408(d)(4).
The "adjusted closing balance" is the fair market value of the IRA at the end of the computation period plus the amount of any distributions made from the IRA during the computation period.
The "computation period" is the period beginning immediately prior to the time the particular contribution is made to the IRA and ending immediately prior to the removal of the contribution being returned.
Recharacterizations are, in effect, actions to cancel either 1) a conversion from a deductible IRA to a Roth IRA (408A(d)(6)), or 2) a direct Roth IRA contribution (Reg. §1.408A-5, Q&A-1(a)) by effecting a trustee-to-trustee transfer of the amount back to the original regular IRA, or in the case of a direct Roth IRA contribution, to a regular IRA. This recharacterization may arise because either 1) after the conversion or contribution, the Modified Adjusted Gross Income is greater than permitted for either a conversion or contribution, or 2) the market value for the account that was converted has declined since the conversion. Because the taxpayer is taxed on the value (less basis) at the time of the conversions, if the value falls after the conversion, a lower tax would result if the lower value were used instead of the value at the time of the conversion. Thus where there is a loss in the value of the Roth IRA after conversion, a transfer in a recharacterization of the original contribution less the amount of the losses (plus any income earned after the conversion) back to the regular IRA is considered to be the transfer of the entire original contribution conversion amount back to the regular IRA. The recharacterized conversion contribution is in effect, disregarded. Note that the earnings or losses on the conversion contribution must be transferred along with the original conversion amount back to the regular IRA in the recharacterization. If you fail to recharacterize the conversions because you became ineligible to make the conversion, any amount, including the income from the conversion amount is subject to a 6% excess contribution tax.
Except for the limited exception discussed above in Announcement 99-104, a recharacterization must occur by October 15 of the year following the year for which the original contribution was made. The original contribution must have been made by the time of filing the return (- not including extensions, i.e., April 15, if a direct contribution rather than a qualified rollover contribution) (Announcement 99-57, 1999-24 I.R.B. 50). It is not necessary that an extension was actually obtained for the 6-month period, but the return will need to be amended if the recharacterization occurs after the return was filed. All recharacterizations must be through trustee-to trustee transfers.
Reconversions are conversions (rollover) of amounts from a regular IRA that have been previously converted to a Roth IRA and subsequently recharacterized (returned to a regular IRA by a trustee-to-trustee transfer) either as a failed conversion because the Modified Adjusted Gross Income exceeded the threshold level or the taxpayer wished to void the transfer because the market value of the assets transferred subsequently declined.
Reconversion Rules for 2000 and later years (Reg. §1.408A-5, Q&A-9(a)(1)).
Effective January 1, 2000, an IRA owner who converts an amount from a regular IRA to a Roth IRA during the tax year, and then transfers that amount back to a regular IRA by means of a recharacterization, may not reconvert an amount before the later of the first day following the end of the year of conversion, or the end of the 30-day period beginning on the day on which the IRA owner transfers the amount by the recharacterization.
Example: Taxpayer converted (rolled over) a regular IRA to a Roth IRA on April 15, of 2001. On August 31, 2001 the taxpayer reversed this conversion by recharacterizing it (transferring it back to a regular IRA), in effect voiding the original transfer. Taxpayer must wait to reconvert the later of 30 days after recharacterization (September 30) or the beginning of the next tax year (January 1, 2002). If Taxpayer had recharacterized (reversed the conversion) on December 24, 2001, the later date would be January 23, 2002.
If a reconversion is made before the required period it is treated as a failed conversion subject to corrective action by recharacterization to where it should have been before the improper reconversion. For purposes of determining the time period for reconverting, a failed conversion that failed solely because the Modified Adjusted Gross Income Limits were exceeded (i.e., MAGI later determined to be in excess of $100,000 limit for conversions), is treated as a conversion (Reg. §1.408A-5, Q&A-9(a)(2)). This rule provides the benefit of allowing a reconversion sooner than would otherwise be allowed. The standard rule, above, requires other failed conversions to wait to the beginning of the next tax year.
Example: Taxpayer converts a regular IRA in 2000 to a Roth IRA. When Taxpayer's return is prepared on April 14, (even though Taxpayer was inconsiderate of CPA's time constraints at that time of year by procrastinating to the last minute) it is determined that the Taxpayer was ineligible to open a Roth because the MAGI limit is exceeded. and the amount is recharacterized back to the regular IRA on April 15, 2001 (but no later than October 15). The later ending period date for reconversion is May 15, 2001 rather than January 1, 2002. If taxpayer does reconvert the amount on or after May 15, no further reconversions can occur again until January 2, 2002.
Recharacterizations disregarded or prohibited
There are many other rules concerning multiple recharacterizations and the recharacterizations are disregarded (Reg. §1.408A-6, Q&A-10, Ex. 9), and some amounts cannot be recharacterized (Reg. §1.408A-5, Q&A-4). Basically, these transfers are disregarded in determining taxability of distributions (Reg. §1.408A-6, Q&A-9(d), (e), (f), (g), and (h)). Examples include transfers between Roth IRAs, corrective transfers including net income, a recharacterized transfer from the original IRA contribution to the first IRA (ignored), as well as prior year excess contributions deemed to be made for the current year, amounts erroneously rolled over or transfers from a SIMPLE IRA or SEP IRA (Reg. §1.408A-5, Q&A-4,5), and tax-free rollover and transfers (Reg. 1.408A-5, Q&A-7). Many examples are given in the regulations (Reg. §1.408A-5, Q&A-10).
Recharacterization Election Procedures
An individual must notify both the trustee of the first and second IRA that an amount
is to be recharacterized and include