Taxation of Nonqualified Roth Distributions

In yesterday’s post, I described the two requirements you have to meet in order to avoid all tax on all distributions from your Roth accounts, both Roth IRA’s and Roth 401(k) or 403(b) accounts. But what if you fail one or both of the requirements? Well, the IRS must really love Roth accounts, because the scheme for taxing these distributions (called “nonqualified Roth distributions”) is quite favorable.

First, keep in mind that you paid tax on your original contributions, so you get to recover these tax-free. Makes sense. Now here’s the good part: You get to recover your contributions tax-free before you have to start paying tax on the previously untaxed investment earnings within the account. What a deal! This is totally different from the scheme for taxing distributions from traditional IRA’s with non-deductible contributions (as explained in February 15’s post).

Here’s an example. Let’s say a few years ago you converted a $50,000 traditional IRA to a Roth IRA, and now, with investment earnings, it’s worth $75,000. If you take a distribution of up to $50,000, the distribution is income tax-free even if you don’t meet the two requirements described in yesterday’s post. Only when your aggregate distributions exceed $50,000 do you start to pay tax on the remaining $25,000. And if you can just hold off dipping into the remaining $25,000 until after you meet the two requirements described in yesterday’s post, you can avoid tax on that as well. Shazam!

There’s one trap to be aware of, and it relates to the 10% penalty on distributions before age 59-1/2. If your distribution comes from a Roth IRA, and that Roth IRA was created by conversion from a traditional IRA, and you don’t qualify for any exception to the 10% penalty (catalogued in February 19's post), and the distribution occurs within the five-year period beginning with the year of the conversion, then you’ll have to pay a 10% penalty tax on the distribution even if it is not subject to regular income tax. Is this just too complicated? You bet. Am I making this stuff up? No. Honest.

Another thing to be aware of is that a rollover avoids tax. If your distribution from a Roth IRA is immediately rolled over to another Roth IRA, then you avoid all tax on that distribution. I’ll describe rollover rules in a future post.

This is enough for today.