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Taxation of Roth IRA Distributions

Qualified Distributions
Holding Periods
Penalties
Nonqualified Distributions
Ordering Rules for Distributions
Comprehensive Example of Nonqualifying Distributions
Aggregation Rules
Updates for New Laws, Proposed Regulations, Effective Dates, IRS Pronouncements and Notices
Recharacterizarions and Reconversions

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 59 (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 Distributions.
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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 59 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. 1.408A-6, Q&A-5(c)).
Example: Taxpayer converts a regular IRA to a Roth IRA on February 1 of 2001 and makes a direct contribution of $2000 on the same day.  The holding period for determining whether the conversion has been held for 5 years for purposes of Section 72(t) penalty tax begins on January 1 of the rollover year, 2001.  If the direct contribution is designated for the prior year because it is made before the due date of the return excluding extensions, the holding period for determining whether a future distribution is a qualified distribution begins January 1, 2000.
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Penalties: If the distribution is a qualified distribution, i.e., both the distribution conditions (age 59, 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.
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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:

  1. regular Roth IRA contributions (never subject to tax or early withdrawal penalty)
  2. qualified rollover contributions, on a first-in first-out basis with the taxable portion of each conversion before the nontaxable portion for that conversion. (taxable to the extent not already recognized in income, and subject to the 10% tax if made before the 5-year holding period determined separately for each conversion)
  3. nontaxable portion of each conversion (not subject to income tax or to 10% early withdrawal penalty)
  4. repeat (2) and (3) for each conversion
  5. earnings on direct Roth contributions and conversions (includible in income and subject to 10% penalty)

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 59) apply to nonqualified distributions within the five tax year period from, and attributable to, conversion contributions.  For instance, an owner who has reached age 59 may make distributions before attaining the 5-year period without penalty, although the distribution may be subject to tax.
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Comprehensive Example of Nonqualifying Distribution:

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 59 and does not meet any of the other qualifying conditions under Section 72(t).  The tax consequences are as follows:

Source of Distribution

Total

Roth IRA

Direct

Conversion Contribution

Roth IRA Subject to

Distribution

Value

Contribution

Taxable

Basis

Earnings

Income Tax Penalty Tax
85,000 85,000 10,000 60,000 20,000 -5,000
-10,000 -10.000 -10,000 0 0
75,000 75,000 0
-60,000 -60.000 -60,000 0 60,000
15,000 15,000 0
-15,000 -15,000 -15.000 0 0
0 0 5,000 -5,000*
-5,000 5,000
0 0

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).
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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)).
Each rollover contribution is treated separately and successively on a first-in first-out basis for ordering withdrawals and assessing penalties (Reg. 1.408A-6, Q&A-8(a)).
All conversions within the same year are aggregated (Reg. 1.408A-6, Q&A-9(c)).
All Roth IRAs are treated as one Roth IRA (408A(d)(2)).
All distributions during the year are aggregated as one distribution at the end of the year (Reg. 1.408A-6, Q&A-9(a)).
All distributions from all of an individual's Roth IRAs made during the year are aggregated (Reg. 1.408A-6, Q&A-9(a)).
In applying the Section 72(t) penalty, all Roth IRAs are treated as one Roth IRA and all distributions during the tax year are treated as one distribution and the value of the contract (IRA), income and investment are computed as of the close of the calendar year (408(d)(2)).

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.)
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Updates - New Laws, Proposed Regulations, and Effective Dates, Etc.

Updates - Current Law

2006

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).

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.

2008

The base contribution is scheduled to increase to $5,000 and the catch-up will be $1000.

2010

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.

  1. Acceleration of income inclusion when amounts are withdrawn from the Roth IRA before the fourth year.  To the extent of the income deferred on the rollover, tax will be recognized (408A(d)(3)(E)(i)).
  2. Election to forgo the four year tax deferral and recognize all the income in 1998 (408A(d)(3)(A)(iii)).
  3. Application of early withdrawal penalty to converted amounts. (If converted amounts are withdrawn within the five year period beginning on January 1 of the year of the conversion, then any withdrawals attributable to an amount that would be included in income will also be subject to the 10% penalty on early withdrawals unless one of the exceptions under Section 72(t) apply or it is a corrective conversion back to a regular IRA (408A(d)(3)(F)).
  4. Only one 5-year holding period for both Roth conversions and contributions. Contributions up to the due date of the return (excluding extensions, (e.g. April 15 of the following year) will start the 5-year holding period as of January 1 of the tax year. (e.g., Contributions as of April 15, 2001 will start the clock on January 1, 2000.)  The same is true for any conversion within the tax year (408A(d)(2)(B)).   If you anticipate making a distribution before 2002, there are separate ordering rules for reporting converted IRAs and direct contributions to Roth IRAs for amounts includible in income and for purposes of applying the 10% penalty.  Note that both the traditional and Roth IRA require contributions be made for the prior year  be made by April 15, the due date, excluding extensions.
  5. Multiple Roth IRAs are treated as one Roth IRA for purposes of applying the rules for holding period, withdrawal penalty (408A(d)(4)).
  6. Corrections of erroneous conversions.  If a taxpayer converts a regular IRA to a Roth IRA, and later learns that the the (Modified) Adjusted Gross Income exceeds the $100,000 limit, the taxpayer can "undo" the conversion by a trustee-to-trustee transfer back to a regular IRA by the due date of the return, including extensions (408A(d)(6), (7)).  No deduction may be claimed on the transferred funds and the earnings on the erroneously transferred funds also must be transferred (408A(d)(6)(B)).  Notes: (1) the time for correcting erroneous conversions includes the time for extensions, but the time for making a contribution to a Roth IRA attributable to a particular year does not; (2)  Correcting an erroneous conversion may be a serious problem when the value of the converted funds decline in value. (3) If the AGI is increased as a result of an audit or by filing an amended return and the $100,000 threshold is exceeded, the conversion privilege will not apply and a penalty will be assessed.  The new law only speaks to the original contribution or conversion amount  being transferred.  If the value declines, it is unclear whether a trustee-to-trustee transfer will relieve the taxpayer of making up the decline in value.
  7. Death before four-year period expires.  Any amounts remaining to be included in income that have been deferred on the conversion are included in the income of the taxpayer on the final return of the decedent (408A(d)(3)(B)(ii)(I)).  If the surviving spouse is the sole beneficiary of all the Roth IRAs, the surviving spouse may elect to continue the deferral (408A(d)(3)(E)(ii)(II).
  8. Determining the $100,000 limit for conversions.  The amount to be included in income as result of the conversion is not counted (included) in determining whether the $100,000 (Modified) Adjusted Gross Income limit is exceeded (408A(c)(3)(B)).   Note that for all other purposes where there is an AGI phase-out for computing Taxable income or deductions, the Modified Adjusted Gross Income (MAGI) does include the conversion amounts includible in income.

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.

The Notice gives several examples.  The old method may also be used until further notice is given.
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Recharacterizations and Reconversions

Recharacterizations

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

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
1. the type and amount of the contribution to the first IRA to be recharacterized,
2. the date the contribution was made and year for which it applied
3. a direction to the trustee of the first IRA as to the amount of the contribution and net income allocable to the contribution to transfer
4. the name of the trustee of the first IRA and second IRA and any additional information needed to make the transfer.

The taxpayer must notify the IRS of the election by attaching form 8606 to the return. A statement should be attached explaining the transfer.
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