Non-Qualified Roth IRA Distributions

What types of withdrawals are non-qualified Roth IRA distributions?

If you want to avoid an unnecessary or unexpected IRS tax bill, not to mention an early withdrawal penalty, you need to know.

But before we answer that question, let's answer this one...

What are qualified Roth IRA distributions?

A qualified Roth IRA distribution is a withdrawal which is tax-free and penalty-free.

Generally speaking, a withdrawal from your Roth IRA must meet two requirements in order to earn the designation of a qualified distribution. Otherwise, it's a non-qualified Roth IRA distribution...

1) You must be at least 59 ½ years old when the distribution occurs
2) Your Roth IRA must be open and funded for at least 5 tax years prior to the distribution

Distributions which meet these two requirements are always qualified distributions.

Early Roth IRA Distributions

So what's a non-qualified Roth IRA distribution?

It's a Roth IRA withdrawal that is NOT tax-free and penalty-free.

Distributions which fail to meet the 5 year rule and the age 59 ½ requirements are generally designated non-qualified Roth IRA distributions, or early withdrawals.

For instance, if you're 63 years old, you meet the minimum age requirement for making a qualified distribution... 59 ½. But any investment gains you withdraw from your Roth IRA are NOT qualified distributions unless you also meet the 5 year rule.

So, in this case, if you opened and funded your Roth IRA or converted a Traditional IRA to a Roth at age 60, then you haven't met the requirements of the Roth IRA 5 year rule yet. In such a case, any investment gain withdrawals are non-qualified distributions.

So why does it matter?

Because non-qualified Roth IRA distributions are subject to income taxes, penalties, or both. But qualified distributions are always tax-free and penalty-free. And if you withdraw money tax-free and penalty-free, you save money.

And you like saving money... Right?

Other Qualified Roth IRA Distributions

So, is it possible for a distribution prior to age 59 ½ or prior to the end of the 5 year holding period to be a qualified distribution?

Yes.

But unfortunately there's only three (3) such cases...

• Death
• Disability
• First Home Expenses

Do you see why I used the word "unfortunately"? Two of the exceptions for meeting the 5 year rule and the age 59 ½ rule involve either your death or your disability. Nevertheless, it's a good idea to know these rules and pass your knowledge on to any loved ones who might take care of your affairs in the event of your untimely death or a sudden disability.

So take the time to learn a little bit about each of these special qualified Roth IRA distributions...

1) Death - In the event of your death, your beneficiary can close out your Roth IRA and the IRS will treat closure in the same manner as a qualified distribution. Even if you had yet to reach age 59 ½ or meet the requirement for the 5 year holding period, closing the account will NOT trigger a Roth IRA early withdrawal penalty or an income tax liability. However, your beneficiary still needs to check with an accountant and/or tax attorney to insure that inheritance taxes, estate taxes, or tax liabilities are not due.

2) Disability - In the unfortunate event that you become disabled, the IRS treats withdrawals of Roth IRA investment gains in the same manner as a qualified distribution. However, before qualifying for this exception, you must meet the definition of "disabled" as outlined in IRS Code Section 72(m)(7) and IRS Publication 590. Only then you can take a distribution from your Roth IRA tax-free and penalty-free. However, make sure you consult with a tax attorney or an accountant in order to verify that you meet the government's definition of "disabled." You don't want to get hit with unexpected taxes and penalties!

3) Purchase of a First Home - If you withdraw investment gains from your Roth IRA to pay for the cost of purchasing a first home for yourself, your spouse, your children, and/or your children's descendants, then the withdrawal is treated as a qualified distribution. It isn't subject to income taxes or the 10% early withdrawal penalty. However, this exception is limited to a lifetime total allowance of up to $10,000.

What does that mean?

It means you can do this four times for four different family members at $2,500 a pop. Or you can do it once for one family member for $10,000. Or you can take advantage of an endless number of combinations which add up to $10,000. But once you hit that $10,000 mark, you can't ever take advantage of this tax-free, penalty-free distribution again. At that point, it's gone forever!

Penalty-Free Non-Qualified Roth IRA Distributions

While the aforementioned instances are the only exceptions which meet the criteria of a qualified Roth IRA distribution, there is such a thing as a penalty-free non-qualified Roth IRA distribution. In fact, there are five (5)...

• Substantially Equal Periodic Payments
• Higher Education Expenses
• Unreimbursed Medical Expenses
• Medical Insurance Premiums
• An IRS Levy

If your distribution meets the IRS standard for any of these five types of withdrawals, your Roth IRA investment gains are NOT subject to the 10% early withdrawal penalty. However, they ARE subject to income taxes.

If you ever find that any of these situations apply to you, avoiding the 10% early withdrawal penalty can save you a lot of money. So take the time to learn a little bit about each of these special penalty-free non-qualified Roth IRA distributions...

1) Higher Education Expenses - If you withdraw Roth IRA investment gains to pay for qualified higher education expenses for yourself, your spouse, your child, and/or any descendant of your child, the IRS views the withdrawal as a penalty-free, non-qualified distribution.

So what is a "qualified higher education expense"?

According to IRS Publication 970, tuition, fees, books, supplies, equipment, room and board, and some additional expenses at any eligible educational institution are all qualified higher education expenses. However, please note that repayment of a student loan is NOT counted as a "qualified higher education expense," so make sure you know the rules before you make any long-term decisions based on this provision.

Also note that this type of distribution is penalty-free, but your investment gains are still subject to income tax.

2) Substantially Equal Periodic Payments - If you receive a series of "substantially equal periodic payments" based on your current life expectancy, the IRS views these withdrawals as penalty-free non-qualified distributions. As a result, you avoid paying a 10% Roth IRA early withdrawal penalty, but any investment gains are subject to applicable income taxes.

3) Unreimbursed Medical Expenses - If you withdraw Roth IRA investment gains to pay for unreimbursed medical expenses which exceed 7.5% of your adjusted gross income (AGI), the IRS treats such a withdrawal as a penalty-free non-qualified distribution. As such, you don't get hit with a 10% early withdrawal penalty. But any investment gains withdrawn remain subject to applicable income taxes.

4) Medical Insurance Premiums - If you withdraw Roth IRA investment gains to pay for medical insurance premiums after receiving unemployment benefits for more than 12 weeks, the IRS views the withdrawal as a penalty-free non-qualified distribution. You avoid paying a 10% early withdrawal penalty, but you still owe income taxes on any investment gains withdrawn.

5) Payment of Back Taxes - If you withdraw Roth IRA investment gains to pay off back taxes resulting from an IRS levy placed against you, the IRS treats the withdrawal as a penalty-free non-qualified distribution. However, any investment gains you withdraw are still subject to income tax.

Conclusion

Knowing the difference between a qualified Roth IRA distribution and a non-qualified Roth IRA distribution can literally save you thousands of dollars.

So take the time to learn the difference. Then use your knowledge and understanding to make good financial decisions for both yourself and your family.

Remember, it's your money. You worked hard for it. You saved it. So don't risk losing it to unnecessary taxes and penalties!