Over the past two weeks we've reviewed the Roth IRA contribution and eligibility rules (the stick). This week we'll review the tax treatment of qualified distributions from Roth IRAs (the carrot).

Qualified Distributions:
Any qualified distribution from a Roth IRA is not included in gross income for individual tax purposes. Simple as that. In effect, a qualified distribution from a Roth IRA is tax free -- no taxes due on the principal, no taxes due on the earnings, no taxes due period.

To be qualified, the distribution must be:
1. Made on or after the date you become age 59-1/2; or
2. Made to your beneficiary, or to your estate after you die; or
3. Made to you after you become disabled within the definition of the IRS code;or
4. Used to pay qualified first-time homebuyer expenses (you can read more about Qualified First-Time Homebuyer expenses in my article on this very subject in the Taxes archive area).

Feel good about life because you've met one of the qualified distribution rules above? Thinking about taking a "qualified" distribution right now? Well, don't stop reading quite yet... there is one more mountain to climb to make your Roth IRA distribution qualified -- the dreaded "five-tax-year rule." Even if one of the above qualifications is met, the distribution is still not qualified if it is made within a five-tax-year period.

Conversely, many people are under the impression that as long as the Roth IRA funds are maintained in the Roth IRA account for more than five years, any distribution after that time will be treated as tax-and penalty-free. Again, nothing could be further from the truth. In effect there are two sets of rules that must be met before a Roth IRA distribution becomes qualified and, therefore, tax free — the distribution rules and the five-tax-year rules. Unless both sets of rules are met, the distribution will not be qualified and the earnings will be subject to tax, and possibly penalties (which we'll discuss in detail next week).

Let's look at how a misunderstanding caught Bill by surprise.

Example #1: Bill, who is 25, made a Roth IRA contribution of $2,000 in 1999. In 2006 (well beyond the five-tax-year period), Bill closes his Roth IRA and takes the total of $4,500 (representing the original $2,000 contribution and $2,500 in earnings) as a distribution. Bill is not disabled, nor does he use these funds to pay first-time homebuyer expenses. Since Bill is not over age 59-1/2 when he takes the distribution, the distribution is not qualified. While Bill will receive his original $2,000 contribution free from tax and/or penalty, he will owe income taxes on the $2,500 of earnings. Additionally, Bill will pay a 10% "early" distribution penalty tax on the $2,500 of earnings from the account. Ouch.

Remember that under the Roth IRA rules, and unlike the rules for a regular IRA, you can first remove your contributions without tax or penalty. But, let's go back to Example #1 above. If Bill decided to take a withdrawal of only $2,000, this withdrawal would be treated as a distribution of his original contributions, and would not be subject to taxes or penalties. This only makes sense, because Bill didn't get to deduct that contribution from his taxable income when it was originally made (so, he's already paid income tax on the money).

The lesson? Don't get too creative here. The IRS has ordering rules that must be followed whenever you take a distribution from a Roth IRA. We'll talk about the ordering rules in the weeks to come, but don't think that you can take whatever you want out of your Roth IRA anytime you want with impunity. The IRS will tell you exactly what you took out… according to the ordering rules.

To make matters even more complicated -- Roth IRAs that contain both conversions and regular contributions fall under a slightly different set of rules. It's still possible to remove your contributions (tax-and penalty-free) from a Roth IRA that contains both contributions and conversions, but the rules can get a bit more complex. What are those rules? You'll just have to hold your horses...'cause we'll discuss 'em in detail next week. So just beware.

And please, if you are unsure about the definition of a "conversion" and/or a "contribution" to a Roth IRA, you really should read Part I and Part II of this series. The distinction between a Roth contribution and a Roth conversion are extremely important. You really must have a working knowledge of those terms before you can plan any Roth IRA distribution. For your own sake, make sure you know the difference.

Bottom line:To receive the maximum benefit from your Roth IRA in the form of tax-free earnings, you must meet at least one of the four distribution rules listed at the beginning of this article and you must also meet the five-tax-year rules. If you blow it on either set of rules, some (or all) of your distribution could be subject to taxes and penalties.

The Five-Tax-Year Rule
Let's take a few minutes to discuss the five-tax-year rule. The first thing to understand is that five tax years is not necessarily the same as five calendar years. The five-tax-year waiting period for a qualified distribution may be shorter than five calendar years, especially if a contribution is made after the close of the tax year for which it is recognized. Remember that you have until April 15 of the following year to make a contribution for the current tax year. And, according to the law, the first year that is counted is the year for which the contribution is made, not the calendar year in which the contribution is actually made. In effect, the very earliest date that a "normal" (i.e., no special issues such as death or disability) qualified Roth IRA distribution could possibly be made is January 1, 2003 because you couldn't contribute to a Roth IRA before January 1, 1998. The following example will bring this point home:

Example #2: Mike, at age 57, made a $2,000 contribution to his Roth IRA on April 15, 1999 for tax year 1998. On January 2, 2003, Mike withdraws $3,000 from his Roth IRA (he will be over age 59-1/2). Of the $3,000 withdrawn, $2,000 represents the original contribution, and $1,000 represents the earnings. This entire distribution is qualified, and is not included in Mike's taxable income because it was made after the expiration of the five-tax-year period and Mike was over age 59-1/2 when he took the distribution. For purposes of the five-tax-year rule, 1998 counted as the first tax year, and the five-tax-year period expired at the end of 2002. So, even though Mike had his funds in his Roth IRA for less than four calendar years, he has met the five-tax-year rules, and his distribution is qualified.

Once the five-tax-year holding period is met, any distribution from the Roth IRA will be excludable as a qualified distribution if it is made after age 59-1/2 or if it meets one of the other requirements for a qualified distribution. And this is true even if you later add a contribution or conversion to that same Roth IRA account. In effect, the FIRST contribution or conversion begins the five-tax-year clock ticking.

Stop right there. Were you just "skimming" this article? If so, I want you to take a few seconds to re-read that last paragraph. It's a very important concept...and one that I want you to have down cold. Your five-tax-year clock begins to tick in the first year a contribution and/or conversion is made to your Roth IRA account...regardless of what you happen to contribute or convert to your Roth IRA in future years. Still not clear? Then, let's take a look at Frank.

Example #3: Frank, age 58, makes a $2,000 contribution to a Roth IRA on April 15, 2000 for the 1999 tax year. In August of 2000 he makes his $2,000 contribution for tax year 2000. In January 2001, he makes his $2,000 contribution for 2001 and also makes a $30,000 conversion from his traditional IRA to his Roth IRA. In July 2002, he converts another $20,000 to his Roth IRA from his regular IRA. In February 2003, he makes a $4,000 contribution ($2,000 each for tax years 2002 and 2003). In January 2004, when Frank is 62 years old, the value of his Roth IRA account is $100,000 ($60,000 of contributions/conversions and $40,000 of earnings). Frank takes a distribution of the entire balance of his Roth IRA account.

Is Frank's $100,000 distribution tax- and penalty-free? You bet your bippy!! The entire amount is a qualified distribution, and no part of the distribution will be subject to tax or penalty. Why? Because, at the time of the distribution, Frank was over age 59-1/2 and the five-tax-year period was met. Frank's five-tax-year clock began ticking in 1999 (the tax year for which his first contribution and/or conversion was made) and expired on December 31, 2003. Since his distribution took place after the December 31, 2003 date, his entire distribution is qualified and not subject to taxes or penalties. All of the transactions that took place in his Roth IRA account after the initial contribution were meaningless for the five-tax-year holding rules.

Armed with this newfound knowledge, you are now able to compute the exact day when your Roth IRA distributions will become qualified. Take a few moments and dream those beautiful dreams of the day that you take your earnings out of your Roth IRA and thumb your nose at Uncle Sammy. I'll bet it almost brings a tear to your eye.

Finally, you may be under the mistaken impression that Roth IRA contributions and conversions must be maintained in completely separate Roth IRA accounts. It's just not true any longer. Under the old Roth IRA rules, contributions and conversions had different five-tax-year rule starting dates...based on when the contribution or conversion was actually made to the Roth IRA account. Because of these staggered starting dates the IRS suggested that contributions and conversions be maintained in separate Roth IRA accounts. That suggestion was made to the various financial institutions, and the institutions passed the suggestion on to their clients.

But, with the changes made to the Roth IRA rules by the Tax Reform Act of 1998, the need for these "separate" accounts has been made moot. It's now acceptable to "co-mingle" your Roth IRA conversions and contributions, since the same five-tax-year rules apply to both. So, if your broker still insists that you segregate your conversion funds and contribution funds, make sure to tell him (or her) of the new law that removed the segregation restrictions.

That being said...there may be times when you do want to maintain more than one Roth IRA account. Can't think of when that would be? Well, then check out my article entitled "How Many Roth IRAs Do You Need?" in the Taxes archive area.

Complicated? Sure...a little. But certainly better than under the old law. Thank heaven for small favors. Next week we'll look at the taxation and penalty issues of nonqualified Roth IRA distributions. Stay tuned.

If you like the way Roy Lewis simplifies confusing tax issues, check out his just-published book, The Motley Fool's Investment Tax Guide 2000: Smart Tax Strategies for Investors. This handy 360+ page guide covers just about every tax aspect of a typical Fool's life: investing, marriage, children, education, homes, home offices, retirement accounts, medical expenses, and much more.)

January 28, 2000

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