Qualified Roth IRA Distributions

What are qualified Roth IRA distributions?

If you intend to withdraw investment gains from your Roth IRA anytime in the near future, you need to know the answer.

Why?

Because qualified distributions are both tax-free and penalty-free. And after all, that's the whole point of making annual Roth IRA contributions, right?

To withdraw tax-free money on a later date?

So if you want to withdraw tax-free, penalty-free funds from your Roth IRA, you need to know the difference between a qualified distribution and a non-qualified distribution.

What Constitutues a Qualified Roth IRA Distribution?

A qualified Roth IRA distribution is any withdrawal of earnings from your account which meet the following requirements:

1) The distribution is made after the 5 year holding period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and

2) The payment or distribution is:

• Made on or after the date you reach age 59½,
• Made because you are disabled,
• Made to a beneficiary or to your estate after your death, or
• Used to pay for expenses related to the purchase of a first home

Keep in mind that these rules apply only to the earnings in your Roth IRA. You can withdraw your original principal contributions at any time tax-free and penalty-free. In fact, according to the Roth IRA ordering rules for distributions, you must withdraw all of your original principal contributions and conversion amounts before you can withdraw a single penny of investment gains.

Meeting The 5 Year Rule

Simply stated, the 5 year rule requires your Roth IRA account to be open and funded for at least five tax years before you can make a qualified withdrawal. The moment you make your first Roth IRA contribution, the clock starts ticking.

For example, suppose you open a Roth IRA and make a contribution to it on June 12, 2010. When does your account meet the requirements of the 5 year rule?

On January 2, 2015.

Why?

Because, by that date, five tax years will have passed. 2010... 2011... 2012... 2013... and 2014.

So before you can make a qualified Roth IRA distribution, you need to make sure your account is in compliance with the 5 year rule.

But that's just one part of a two part process...

In order to obtain the status of "qualified distribution," your Roth IRA withdrawal must meet the 5 year requirement, plus one of the additional requirements outlined below:

Age 59 ½

After you reach age 59 ½, assuming your account meets the 5 year rule, all the funds you withdraw from your Roth IRA count as qualified distributions.

For instance, let's say you opened a fully-funded Roth IRA in 2001 at age 51. Now, fast forward to 2012. You now want to withdraw some of your Roth IRA earnings in order to supplement your pension income...

If you do, will you owe any taxes or penalties of your distribution?

No.

Why?

Because you're now 62 years old (2 ½ years past the minimum age requirement) and your account has been open for 11 full tax years (fully satisfying the 5 year Roth requirement).

But, had you been younger than age 59 ½ or your account was less than 5 tax years in age, then your withdrawal would not constitute a qualified Roth IRA distribution.

Are there any instances where you can take a qualified distribution prior to age 59 ½?

Yes. But they aren't necessarily common...

The IRS Definition of Disabled

If you become disabled prior to reaching age 59 ½, then assuming your account meets the 5 year rule, any distributions you take from your Roth IRA are considered qualified distributions and are NOT subject to income taxes or the 10% early withdrawal penalty.

However, before taking a distribution, make sure you meet the IRS definition of disabled. According to IRS Publication 590, a disabled person is as follows...

"You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued, or indefinite duration."

While in your everyday life, you might be labeled as "disabled," you might not meet the IRS definition of disabled. So make sure this provision really applies to your situation before taking a distribution.

Payment to a Roth IRA Beneficiary

If you pass away prior to age 59 ½, assuming your account meets the 5 year rule, the beneficiary of your Roth IRA can withdraw the full balance of your account as a qualified distribution, meaning the full balance of your account is tax-free and penalty-free.

Or, if they so choose, your beneficiary can treat your Roth IRA as their own, which means for all intents and purposes, they replace you as the official account holder. However, please note that if your beneficiary chooses this option, he or she is now subject to the normal rules governing a Roth IRA.

That means they can?t decide a few years later to take a qualified distribution based on your death.

For instance, let's say you're 34 years old with $50,000 in your Roth IRA, and your spouse is your designated beneficiary. If you die, your spouse inherits your Roth IRA. In such a scenario, your spouse can choose one of two options...

1) Take a qualified distribution in the amount of $50,000.

2) Assume ownership of your Roth IRA.

In Scenario 1, your spouse receives the entire $50,000 tax-free and penalty-free.

In Scenario 2, your spouse obtains a Roth IRA with $50,000 in assets which continue to grow tax-free indefinitely. However, if your spouse attempts to withdraw funds prior to age 59 ½, then the withdrawal is treated as a non-qualified Roth IRA distribution, subject to applicable income taxes and a 10% early withdrawal penalty.

So be careful, once the second option is chosen, you can NOT go back and choose the first.

First Home Purchase Expenses

You can also take a qualified Roth IRA distribution of up to $10,000 (a lifetime limit) to pay for expenses related to a first home purchase. You can use this money to pay such expenses for yourself, your spouse, a child, a grandchild, or any direct descendants of your children.

The IRS considers you a first time home buyer if you maintain no ownership interest in a home for at least a two-year period ending on the date of acquisition of the home which you are buying, building, or rebuilding.

Keep in mind that if you're married and plan to take advantage of this distribution for yourself or your spouse, both you and your spouse must meet this requirement. However, if you're taking this distribution for your child, only your child (and spouse, if your child is married) must meet this requirement.

For example, let's say your daughter is buying her first home. After several years of saving, she's managed to accumulate a good-sized down payment for the transaction. However, after making the down payment, she doesn't have enough money left to pay $4,000 in closing costs.

In such a scenario, you can take a qualified Roth IRA distribution of $4,000, tax-free and penalty-free. Your daughter can pay her closing costs, and you maintain the flexibility to take future first home purchase qualified distributions of at least $6,000.

Conclusion

Qualified Roth IRA distributions are tax-free and penalty-free, while non-qualified distributions are not.

As such, it's a good idea to know what constitutes a qualified distribution, because those are obviously the most desirable types of distributions.

Generally speaking, you must meet the 5 year rule and one of the following...

• Reach age 59 ½ or older
• Meet the IRS definition of disabled
• Pass away and leave the account to a beneficiary
• Use the funds for expenses related to a first home purchase

Regardless of whether or not you meet any of the four criteria above, your distribution is NOT qualified unless your account also meets the 5 year requirement. To summarize, a qualified Roth IRA distribution is a two step process ? 1) meeting the 5 year rule, and 2) meeting one of the remaining requirements.

Remember those rules, and you never have to worry about unexpected taxes or penalties...