Because so many individuals have a substantial percentage of their net worth invested in IRAs (either traditional or Roth), it is important to understand the tax consequences and rules regarding IRA distributions.
Roth IRA Distributions
There are two types of distributions from a Roth: qualified distributions and nonqualified distributions. A qualified distribution is generally any distribution from a Roth that is made: a) after a “waiting period” on a taxpayer who is 59 ½ or older; b) on account of a taxpayer’s disability; c) for a qualified first-time home purchase (up to $10,000); or d) to an estate or beneficiary due to the Roth owner’s death. For most distributions, the “waiting period” is the five-year period beginning on January 1 of the initial tax year of the first Roth contribution. The five-year waiting period also applies to each Roth conversion. Qualified distributions are generally not subject to federal income tax.
All other distributions from a Roth are “nonqualified.” Some or all of a nonqualified distribution may be subject to income tax and to a 10% withdrawal penalty. The penalty may be avoided if the taxpayer is age 59 ½ or older, the distribution is made as a part of substantially equal periodic payments, the distribution is made to a beneficiary on account of the Roth owner’s death, the distribution is made on account of a disability, or the distribution is paid to a taxpayer for a first-time home purchase. The withdrawal penalty will also not be imposed if the distribution is not in excess of any of the following expenses: a) qualified higher education expenses; b) certain medical insurance premium expenses paid while unemployed; or c) certain medical expenses.
To determine the tax and penalty consequences of nonqualified distributions, the following rules generally apply: (1) all distributions up to the total annual Roth contributions are tax and penalty free; (2) the taxable amount of IRA conversions (i.e., amounts subject to tax at conversion) are tax free, but may be subject to the 10% penalty if no exception applies; (3) the nontaxable amount of IRA conversions (generally meaning the return of nondeductible IRA contributions) are tax-free and penalty free; and (4) Roth earnings are taxable and may be subject to the10% withdrawal penalty, unless an exception applies.
Traditional IRA Distributions
Like Roth IRA distributions, distributions from traditional IRAs may be taxable and subject to the same 10% withdrawal penalty for most distributions taken before the owner is age 59 ½. If a taxpayer has contributed only deductible IRA contributions, the taxpayer has no basis in the IRA and all distributions will be taxable. If a taxpayer has made nondeductible contributions, distributions will be partially taxable since those contributions represent the taxpayer’s basis in the IRA. When computing the taxable and nontaxable amounts, all of a taxpayer’s traditional IRAs are treated as one — a taxpayer may not decide whether a distribution will be from deductible or nondeductible contributions.
The taxable percentage of a distribution is the total year-end value of all IRAs (plus the amount distributed, but minus the nondeductible contributions remaining at the beginning of the current year) divided by the total year end value of the IRAs plus the amount actually distributed. With respect to the 10% withdrawal penalty, the same exceptions which apply for Roths also apply to traditional IRAs.
Which Account Should I Receive Distributions From First?
Taxpayers who are actively taking IRA distributions and own both Roth and traditional IRA accounts (generally, those over age 59 ½) must decide whether and to what extent the taxpayer will accept withdrawals from the accounts. Those taxpayers who are over age 70 ½ must generally comply with required minimum distribution rules for traditional IRAs, but those rules have been suspended for 2009.
When comparing traditional IRA distributions to Roth distributions, an owner’s first inclination may be to exhaust the Roth assets since the distributions will not generally be subject to income tax. However, it may be wise in the current market to satisfy distributions from traditional IRAs first – because Roth IRAs appreciate tax-free. In addition, there are no required minimum distribution rules for Roth IRAs – so leaving money in a Roth IRA may provide more flexibility and derive greater after-tax savings. Thus, owners must not only consider the current tax cost of distributions, but also the minimum distribution rules and the tax consequences of future appreciation.