When Can I Take a Roth Distribution? It’s About the Rules

You can take money out of your Roth IRA. Generally there is no income tax due on a distribution, but if you are under age 59 1/2, you may owe the 10% early distribution penalty. Here’s the way it works.

In order for all Roth distributions to be tax and penalty free, you must be at least 59 1/2 AND have established any Roth IRA 5 years ago OR the distribution is due to death, disability, or is for a first-time home purchase.

It is more complicated if you are under age 59 1/2. All of your Roth IRAs are treated as one big Roth IRA. You have to track three types of funds in your Roth IRAs: 1) your contributions; 2) your conversions; 3) your earnings.

When you take a Roth distribution, your contributions are the first funds distributed, even if they are in a different account from the one that makes the distribution. Contributions are distributed tax and penalty-free.

When your contributions are gone, then you start on your converted amounts; first in, first out. Each Roth conversion has its own 5-year holding period. If the funds are distributed before the 5 years are up for that conversion and you are still under age 59 1/2, then you have to pay the 10% penalty on the amount distributed. Now, if the funds were after-tax funds when they were converted, there is no penalty. This means that you could be under age 59 1/2 at the time of the distribution and not owe a penalty if the Roth conversion was done more than 5 years ago.

When your contributions and conversions are exhausted, then you are taking distributions of the earnings on the Roth account. The earnings will be taxable and subject to the 10% early distribution penalty since you are under age 59 1/2.

Those are the distribution rules in a nutshell. However, we do NOT recommend that you take funds from your Roth account to pay the income tax due on a Roth conversion unless you absolutely have no other way to pay the tax. You will be reducing the amount you have available in retirement and you are losing all of the tax-free compounded interest on what you withdraw. It could be the difference between living comfortably and having to make tough choices about where to cut back during retirement.

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Private Letter Ruling 201211034

“Frank” had a will that established a trust for his wife “Susan.” He named the trust as the beneficiary of the IRA, but he later revised his will to eliminate the trust entirely and leave his entire estate outright to Susan. Or so he thought. Frank did not update the IRA beneficiary designation form, which still listed the testamentary trust.

Big mistake.

At Frank’s death, the beneficiary of his custodial account was deemed to be his estate. Why? Because the beneficiary form trumps all and it was not updated to avoid the estate and pass his assets to Susan as he intended.

As the surving spouse and sole beneficiary of Frank’s estate, Susan requested a ruling to roll over the proceeds from his IRA to her IRA in a trustee-to-trustee transfer.

IRS ruled that Susan could either transfer the proceeds from her husband’s IRA by trustee-to-trustee transfer into an IRA set up in her own name or take a distribution of the IRA’s proceeds and complete a rollover into an IRA set up and maintained in her name as long as the rollover satisfied the 60-day rollover rule.

LESSON TO LEARN:
If the beneficiary form had been updated after the will was changed, then the IRA would not have had to go through the estate to the wife, and she would not have had to pay the IRS $10,000 for the PLR plus a preparer’s fee. Don’t forget to check and update all beneficiary forms.