Tax-Free Roth Distributions

One of the beauties of Roth savings is that distributions can be totally tax-free. All those years’ worth of investment earnings can escape the ravages of income taxation!

Note the use of the word “can.” As with all things tax-related, there are requirements to be met to get this valuable benefit, and that’s the subject of today’s post. For a distribution from a Roth IRA or Roth 401(k) account or Roth 403(b) account to be totally tax-free, the distribution has to meet two requirements: (i) It has to follow a triggering event; and (ii) it has to meet the five-year requirement.

Triggering Event. Only four triggering events qualify. Any one will do. Here they are:
1. Age 59-1/2. This is the most common situation. Any distribution after you reach age 59-1/2 meets this first requirement. Who came up with that half-birthday concept?
2. Death. Any distribution to your beneficiary following your death meets this requirement.
3. Disability. Any distribution attributable to your disability also meets this requirement. The Tax Code uses a rather strict definition of “disability.”
4. First-time home buyer. A distribution of up to $10,000 to enable you, your spouse, a child or a grandchild to purchase a first home qualifies. This triggering event applies to Roth IRA’s but not Roth 401(k)’s or 403(b)’s.

Five-Year Requirement. Okay. Let’s say you’ve met the first requirement, say because you’re age 65. Not so fast, Kemosabe. Your Roth account also has to meet a five-year holding period requirement. The distribution has to occur after the following date:

Roth IRA: After the end of the five-year period beginning with the first day of the year for which you made your first Roth IRA contribution, or during which you first converted a traditional IRA to a Roth IRA. Once you’ve met this holding period, you’ve passed the test for all time and for all of your Roth IRAs. This particular clock only has to run once, and then you’re good to go.
Roth 401(k) or Roth 403(b): After the end of the five-year period beginning with the first day of the year in which you made your first Roth contribution to the 401(k) plan or 403(b) plan. Since these types of accounts first began in 2006, nobody will meet this requirement until January 1, 2011 at the earliest. Generally, unlike Roth IRA’s, a separate five-year cock has to run for each 401(k) plan or 403(b) plan in which you participate.

Here’s a good idea, particularly for people age 54 or older: Because of the five-year requirement, if you think there might be meaningful Roth savings in your future, it’s a good idea to make a Roth contribution as soon as it’s allowed, just to start the running of the five-year clock. A small token Roth contribution will do. Or converting a token amount from an existing traditional IRA will also do; which is just another reason to look forward to 2010, as explained in February 28’s post.

What if you fail one of the two requirements? Take heart. All is not lost! But that subject will have to wait for tomorrow’s post.