In a recent article in “Retirement Watch,” published by Bob Carlson, he clarified when distributions from Roth accounts are tax free and when they are not. It is important for you to understand when distributions from Roth accounts are not tax free. If you understand the two different five-year rules associated with Roth accounts, you should be able to avoid any taxes associated with withdrawals from your Roth accounts.
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Roth distributions to original owners are tax free when they are “qualified distributions.” In order for the distribution to be qualified, it must satisfy what is generally called the “five-year rule.” However, there are two five-year rules. One rule determines whether a distribution avoids income taxes. The second five-year rule determines if a distribution taken before age 59 1/2 avoids the 10% early distribution penalty tax.
Beneficiaries who inherit Roth IRAs do not need to worry about these rules because they automatically avoid the early distribution penalty and receive tax-free distributions. I have Roth accounts in my IRA, and I have named my son and daughter as beneficiaries, so neither of them will face income taxes on these accounts when they inherit them.
The distribution of principal from a Roth IRA is always tax-free because the income taxes have already been paid. So, the issue of taxation is related to whether distribution of income and gains are taxable.
For a distribution to be qualified and avoid income taxes, two tests must be met. One test is that five years must have passed since the first contribution was made to any Roth account of the taxpayer. The five-year period starts whenever money is put into any Roth IRA. Contributions include both direct contributions and rollover contributions from traditional IRAs.
The five-year rule does not apply to each Roth IRA. It applies to the taxpayer. It does not start again if you change custodians. So, any change in custodians will not change the qualification status of your IRA account.
When the five-year rule is satisfied for one Roth account of the taxpayer, it is satisfied for all the Roth accounts owned by the taxpayer for his life. Because of this rule, many advisers recommend that a Roth account be established as soon as possible.
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The second test is broader, The distribution must be made on or after one of the following events: the owner turned age 59 1/2; the owner passed away and the distribution is made to an estate or a beneficiary; or the distribution is made for first-time qualified home buyer of up to $10,000.
Both tests must be satisfied for a distribution to be income-tax free. Penalties would apply only for conversions made before you reach 59 1/2. So, if you have reached 59 1/2 and had a Roth account for five years, both tests are met, and any distribution from any Roth account you own would be qualified and income-tax free.
Early distribution penalty
The 10% early distribution penalty is not imposed if at least five years have passed since the principal was converted. The penalty applies only to accumulated income and gains, not contributions. The rules for this penalty apply separately for each conversion. So, you have to keep track for each conversion made prior to age 59 1/2. The penalty would apply only to calendar years or 12-month periods. A tax year starts on the first day of the year in which the transaction was made. So the five-year period ends less than 60 months from the date of the conversion.
Ordering rules
When a distribution from a Roth account is made less than the full balance, under the ordering rules, the first distributions are principal. Only after all principal is distributed are earnings distributed. So income taxes are not an issue until all the principal is distributed. Thus, you can avoid income taxes by only withdrawing principal, until the five-year holding period is met. Then all distributions will be tax-free.
When a Roth IRA distribution is tax-free, it is not included in adjusted gross income (AGI) or modified adjusted gross income (MAGI) used to determine taxable Social Security benefits. So you minimize all your taxes by carefully making tax-free distributions from your Roth accounts.
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Elliot Raphaelson welcomes your questions and comments at [email protected].