by Susan D. Diehl and Gary S. Lesser
© 1998, Susan D. Diehl, Gary S. Lesser
The following chart applies to distributions of earnings from accumulated annual Roth IRA contributions and amounts converted into a Roth IRA from a traditional IRA. For purposes of federal income taxes, in general, annual Roth IRA contributions and amounts converted are recovered free of federal income tax before any gain is distributed (the "contribution-first recovery rule"). In addition, annual Roth IRA contributions are treated as distributed before a converted amount (the "ordering rules"). Although the contribution-first recovery rule is actually part of the ordering rules, the rules are easier to understand if treated as separate rules. However, there is an exception to the contribution-first recovery rule, but not the ordering rule. The exception applies when the income caused by a 1998 conversion is being spread over a 4-year period. In such a case (and only in such a case), to the extent of the unrecovered spread income (which can occur during the first three years), any amount received is accelerated and currently subject to federal income tax to the extent it would have been taxed in a later year under the deferral (and the amount may also be subject to penalty if under age 59½). Note that the exception to the contribution-first recovery rule does not actually cause any gain to be distributed, but rather the unrecovered spread income (which is, in effect, an untaxed contribution).
Even if the conversion tax (if any) is not spread out over a 4-year period (and assuming there is no remaining basis attributable to annual Roth IRA contributions), a converted amount withdrawn before the 5-year period is subject to the 10 percent premature distribution penalty tax (unless an exception applied) to the extent that the distributed amount would have been taxable if it had been distributed from the Traditional IRA and not rolled over or converted. Thus, the amount may be subject to penalty even though the amount may be received (unless accelerated, see above) without any federal income tax liability. For this purpose, the five-year period starts with the year that the conversion amount being withdrawn was made. [IRC 408A(d)(3)(F)(i)(II)] On the other hand, the five-year period that is used for the purpose of determining whether an amount is a "qualified distribution" starts with the year that the first valid contribution is made to the Roth IRA. A qualified distribution of earnings is not subject to federal income tax nor penalty.
Distribution of Roth IRA Earnings |
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Roth IRA Earnings Paid Out WITHIN 5 Years |
Roth IRA Earnings Paid Out AFTER 5 Years |
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| Reason For Distribution | Earnings Taxable |
Subject |
Earnings |
Subject |
| On or after Age 59½ | Yes |
No |
No |
No |
| Before age 59½, see penalty exceptions 1-7 | Yes |
Yes |
Yes |
Yes |
| 1. Death | Yes |
No |
No |
No |
| 2. Disability | Yes |
No |
No |
No |
| 3. First-time homebuyer - $10K limit | Yes |
No |
No |
No |
| 4. Substantially equal periodic payments | Yes |
No |
Yes |
No |
| 5. Medical expenses above 7½% of AGI | Yes |
No |
Yes |
No |
| 6. Insurance premiums by unemployed | Yes |
No |
Yes |
No |
| 7. Higher education expenses | Yes |
No |
Yes |
No |
Authors:
Susan D. Diehl of PenServ and Gary S. Lesser (who may be reached at qpsep@pixpc.com), are authors of the the Roth IRA
Answer Book (Panel Publishers).