The Roth IRA is a key piece of the New Three-Legged Stool strategy of retirement planning because it represents the tax-free leg of the stool. However, a distribution from a Roth IRA is not tax-free unless it is a “qualified” distribution. Qualified distributions from Roth IRAs are tax and penalty free, but non-qualified distributions may be subject to tax and an early distribution penalty.
A distribution is qualified once the Roth IRA owner has reached age 59 ½ and the Roth account is at least five years old. There are three exceptions:
- First home buyer. The distribution is used toward the purchase, or to build or rebuild a first home for the Roth IRA holder or a qualified family member. This is limited to $10,000 per lifetime.
- Disability. The Roth IRA holder becomes disabled.
- Death. Distributions are made to the beneficiary of the Roth IRA holder.
Non-qualified distributions not meeting the above requirements may be subjected to income tax and/or the 10% early-distribution penalty. The determining factor is the source of the distribution.
- A regular after-tax contribution: never taxed or penalized.
- Conversion of taxable assets from a traditional IRA or rollover of taxable assets from a company plan: assets are taxed when the conversion occurs. Penalty waived after five years have passed.
- Conversion of after-tax assets from a traditional IRA or rollover of after-tax assets from a company plan: never taxed or penalized.
- Earnings: taxable and subject to penalty if under age 59 ½.
The IRS uses “ordering rules” to determine the source of assets distributed from a Roth IRA. Once assets from one source are used up, the assets are deemed to be distributed from the next source to determine tax and/or penalty. Here is the order in which the IRS determines the source of distributions:
- Regular Roth IRA contributions.
- Taxable Traditional IRA conversions and taxable rollovers from a company plan.
- Nontaxable Traditional IRA conversions and nontaxable rollovers from a company plan.