Two 5-year rules are the benchmarks that determine whether distributions from a Roth IRA are subject to income tax and/or the 10% early distribution penalty.
A Roth IRA is funded with amounts that have already been taxed, and earnings are tax-free as long as distributions are ‘qualified.’ If distributions are non-qualified, income taxes could apply; as well as the 10% early distribution penalty for distributions taken before the account owner reaches age 59½.
The responsibility for determining whether a Roth IRA distribution is subject to income tax and/or the 10% early distribution penalty sometimes falls on the Roth IRA owner, who might pass on that responsibility to an advisor. Regardless of who is responsible, one of the two 5-year rules must be applied when making the determination. One 5-year rule is used for qualified distributions, and the other is used for nonqualified distributions. That one that applies depends on whether the distribution is qualified.
The 2 Roth 5-year rules
Determining taxability of a Roth IRA distribution can seem complex. But much of the complexity can be removed by applying the 5-year rules in the following order.
- 5-year rule #1: This is used to determine if a Roth IRA distribution is qualified.
- 5-year rule #2: This is used to determine if the 10% early distribution penalty applies to nonqualified distributions of conversion/rollover amounts.
For both 5-year rules, an individual’s Roth IRAs are aggregated and treated as one Roth IRA. (This does not include inherited Roth IRAs.)
5-year rule #1: Identifying a qualified distribution
In order for a Roth IRA distribution to be qualified, two requirements must be met. These requirements are:
- The distribution must be made at least five years after the Roth IRA owner makes a contribution to the Roth IRA. This includes regular Roth IRA contributions, Roth conversion contributions, and rollover contributions from employer-sponsored retirement plans. And
- The distribution is made under at least one of the following four circumstances:
- The Roth IRA owner is at least age 59½ on the date the distribution is made.
- The distribution is attributable to the Roth IRA owner being disabled (as defined under Tax Code section 72(m)(7)).
- The distribution is used for eligible first-time home buyer expenses. This is subject to a lifetime limit of $10,000.
- The distribution is taken from an inherited Roth IRA by the Roth IRA owner’s beneficiary.
If a Roth IRA distribution satisfies these two requirements, then the entire distribution amount is tax-free and is not subject to the 10% early distribution penalty.
For 5-year rule #1, the clock starts January 1 of the first year for which a contribution is made to any of the individual’s Roth IRAs.
- Example 1: Assume that Susie made her first Roth IRA contribution in March of 2018, for 2017. Her starting clock for 5-year rule #1 begins on January 1, 2017. If the contribution had been made for 2018, then the clock would have started January 1, 2018.
- Example 2: Assume that Karen made her first Roth IRA conversion in April of 2018. However, she had also made a regular Roth IRA contribution to another Roth IRA in June 2010. Her starting clock for 5-year rule #1 begins June 1, 2010.
Tip: Making a Roth IRA contribution or a Roth conversion/rollover—regardless of how small—can get the clock for 5-year rule #1 started.
5-year rule #2: Identifying distribution of taxable conversions subject to the 10% additional tax
Five-year rule #2 is used to determine if non-qualified distributions of taxable rollover/conversion amounts are subject to the 10% early distribution penalty. In order to make this determination, one must ascertain the source of funding from which the distribution is being made, by applying the ‘ordering rules’ to a non-qualified distribution.
Under the ordering rules, distributions are made from the following funding sources in the listed order:
- Level 1: Regular Roth IRA contributions and rollover of basis from designated Roth accounts (DRAs). (DRAs are Roth 401(k)s, Roth 403(b)s, Roth 457(b)s and Roth Thrift Savings Plans, or TSPs.)
- Level 2: Conversions from traditional, SEP and SIMPLE IRAs; and rollover of non-Roth amounts from employer-sponsored retirement plans (qualified plans, such as 401(k) and pension plans, 403(b) plans, Governmental 457(b) plans and TSPs).
These amounts are distributed on a first-in-first-out (FIFO) basis. For this purpose, all conversions and rollovers done in one calendar year count as one conversion/rollover for that year.
Further, taxable conversion/rollover amounts are distributed before nontaxable conversion/rollover amounts.
- Level 3: All earnings, including rollover of earnings included in a rollover of a non-qualified distribution from a DRA.
A distribution of funds from Level 2 is subject to 10% early distribution penalty, unless the Roth IRA owner is at least age 59½ at the time the distribution is made or qualifies for an exception to the penalty. One of the exceptions applies to conversion/rollover amounts that have been in the Roth IRA for at least five years (5-year rule #2).
Table 1 gives a summary of the taxability of a nonqualified Roth IRA distribution under the ordering rules.
For 5-year rule #2, each conversion/rollover done in one year is counted as one conversion/rollover for that year. A separate clock for 5-year rule #2 applies to each year in which a conversion/rollover is done.
Let’s look at an example of how this works.
Let’s say 45-year-old Peter has several Roth IRAs. The total of all Peter’s Roth IRA balances are broken down in Table 2:
Peter, having never taken distributions from any of his Roth IRAs before, decides to take a distribution in 2018.
However, Peter is not eligible for a qualified distribution and the ordering rules must be applied to determine the level from which the assets are distributed—so as to identify any portion that is subject to income tax and/or the 10% early distribution penalty.
Scenario 1: If Peter takes a distribution of $20,000, the amount will be tax-free and penalty-free because that amount will come from Level 1.
Scenario 2: If Peter takes a distribution of $95,000, the distribution would come from sources in the following order:
- First: $20,000 from Level 1. This would be tax-free and penalty-free.
- Second: $35,000 Level 2, year 2010 conversion. This would be tax-free because any income taxes owed would have been paid for the 2010 tax year. This $35,000 would also be exempted from the 10% early distribution penalty, because it would have been in his Roth IRA for at least five years before the distribution occurred.
- Third: $32,000 Level 2, year 2015 conversion, from the taxable conversion portion, because taxable conversion amounts are distributed before nontaxable conversion amounts. This amount would be tax-free because any income taxes owed would have been paid for the 2015 tax year. However, this $32,000 would be subjected to the 10% early distribution penalty, because it would have been less than five years since the amount was converted to the Roth IRA.
- Fourth: $8,000 Level 2, year 2015 conversion, the nontaxable conversion portion. This amount would be tax-free because any income taxes owed would have been paid before the amount was contributed to the traditional IRA. Also, since the conversion of this amount was nontaxable, it would not be subject to the 10% early distribution penalty when distributed from the Roth IRA.
To make it easier to keep track of Roth conversion/rollovers by year, some practitioners recommend separating Roth conversions by year into separate Roth IRAs, until the Roth IRA owner is at least age 59½. Copies of IRS Form 8606, which is used to track basis in IRAs, should be retained along with the Roth IRA owner’s tax records.
Tax treatment of earnings
As noted above, a qualified distribution of earnings is completely tax-free. For nonqualified distributions, any amount attributable to earnings would be subject to income tax. Such an amount would also be subject to the 10% early distribution penalty unless the Roth IRA owner qualifies for an exception.
Using the example of Peter above, his distributions would include earnings to the extent the amount exceeds $95,000.
Source: Jul 2, 2018 / www.horsesmouth.com