Roth IRA Withdrawals: Untangling The Rules

by: Bruce Miller

Summary

The Roth IRA began as a simple savings plan for moderate to low income households.

The Roth IRA has been expanded to include high income households.

The rules on Roth IRA withdrawals can get complicated.

As an income investor, I plan on part of our retirement household income to be generated from the dividends paid by stocks I hold in our Roth IRAs (RIRAs) that I will regularly withdraw. I hold most tax inefficient dividends in these RIRAs, such as those paid by Business Development Companies, REITs (common and preferred stock) and interest paying bonds. These dividends are tax inefficient as they would otherwise be taxed at our highest marginal tax rate in a taxable account or from a Traditional IRA (TIRA)... but they will come out of the RIRA tax-free. In my readings, I often see questions relating to the tax treatment of RIRA withdrawals under various circumstances, such as one's age, recent TIRA to RIRA conversions, employer plan designated Roth withdrawals or withdrawals when one is named as the beneficiary on a decedent's RIRA. So I thought it might be timely to discuss how RIRA withdrawals - elective or mandatory - are treated by the IRS. But first…

A little history on the RIRA

RIRAs were first created by the 1997 Taxpayer Relief Act, with the first contribution year being 1998. Like TIRAs, contributions must be in cash and must represent "compensation" or "earned" income that comes directly from work provided during that year from either the IRA contributor or their spouse. (The one exception to 'earned income' is alimony, but I suspect this is a somewhat uncommon source of household income in retirement). Contributions for a given year can be made up until that year's tax filing deadline of (usually) April 15 of the next year, excluding extensions, although the contributor must designate that contribution for the previous year (the default is the actual year of contribution). Maximum contributions have increased over the years as they are periodically adjusted for inflation.

Unlike TIRAs to which contributions may be made up to the year one attains the age 70 ½ but no contributions on or after this age, contributions may be made indefinitely to one's RIRA, providing the owner or spouse has at least the amount of the contribution(s) in earned income. And unlike a TIRA for which annual contributions are not limited by one's Modified Adjusted Gross Income (MAGI), contributions to one's RIRA are not allowed for those whose MAGI exceeds maximums that are adjusted periodically for inflation. In 1998, these MAGI limits were $150,000 (phased out up to $160,000) for those married filing jointly and $95,000 (phased out up to $110,000) for those filing single. These MAGI maximums have increased with inflation over the years, with today's MAGI maximum and phase out ranges of $184,000 to $194,000 and $117,000 to $132,000, respectively.

A TIRA to RIRA conversion has been allowed since 1998 although it was capped at a MAGI of $100,000 until 2009 when this cap was removed. So up until 2009, high income households over the MAGI maximums for Roth contributions could not have a RIRA, and so RIRAs that existed were modest to small in size and not considered terribly important in retirement income planning.

In addition to removing the MAGI cap for RIRA conversions, another rule change originally embodied in the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001, allowed employers to modify their salary deferral plans to add a Roth component that will allow employees, regardless of their MAGI, to contribute to a designated Roth savings plan attached to the employer's 401(k) or 403(b) plans if the employer elected to add this provision, effective for years after 2005. (Later also adding government 457(b) plans but excluding 457(b) non-profit employer plans as well as SIMPLE and SARSEP salary deferral plans)

With these rule changes, the Roth went from a nice-but-insignificant retirement savings vehicle to a major player in retirement income planning, by allowing RIRAs to grow in size to the point they may be primary sources of income for many retired households. But what's important to know for Roth planning purposes? What are the rules for future Roth withdrawals? Are all future withdrawals elective or are there mandatory withdrawals that must be considered. Generally, future Roth withdrawals can be divided into two groups: Qualified RIRA withdrawals and Non-Qualified RIRA withdrawals.

Qualified RIRA withdrawals

The IRS sets two holding rules for a Qualified RIRA (QRIRA) withdrawal:

1. A RIRA must have been opened, funded, and held for 5 consecutive years

AND

2. The RIRA owner must meet one of the 4 following conditions

  • Attained age 59 ½
  • Died (the tax character of distributions would then pass to the RIRA named beneficiary)
  • Disabled
  • Up to $10,000 withdrawn to purchase a first time home

Note that BOTH of these conditions 1 and 2 must be met. Now, what do these mean?

  • The 5-year holding period begins on January 1 of the year for which the first contribution is made. 'Contribution' is used here to mean a direct cash contribution or a conversion contribution. So if an individual makes their first RIRA direct contribution on April 10, 2016, and designates this contribution for 2015, the 5-year period will begin January 1, 2015, and will be met on January 1, 2020.
  • Age 59 ½ means one's birthdate plus 180 days, NOT the year one attains age 59 ½.
  • Death is the year of death and applies to subsequent withdrawals to beneficiaries DUE to the death.
  • Disabled here is the IRS definition of disabled, which means the RIRA owner must be able to furnish proof that he/she cannot do any substantial gainful activity because of their physical or mental condition. A physician must determine that the medical condition can be expected to result in death or to be of long, continued, and indefinite duration.
  • A first time home means the RIRA owner has not been a homeowner for the previous 2 years. This withdrawal may be used for the benefit of the RIRA owner, spouse or lineal descendants, it must be used as a down payment on the home within 120 days of acquisition and the $10,000 is a lifetime maximum withdrawal per IRA owner.

Once the RIRA owner has met both of the above conditions, all $dollars$ in the RIRA have exactly the same tax character: QUALIFIED! QRIRA withdrawals are reported on line 15a of one's form 1040 or 11a of form 1040A, but a 0 is entered in lines 15b or 11b, respectively. QRIRA withdrawals are not used in determining other thresholds, such as the taxability of Social Security benefits, Medicare part B premiums, ACA subsidies or any tax deduction/credit phase-out that I'm aware of. QRIRA distributions are reported by the IRA custodian on form 1099-R with box 7 showing code Q.

Non-Qualified RIRA Distributions

Now things can get a bit complicated! Any withdrawal, elective or mandatory, that does not meet the two conditions above, will be non-qualified RIRA (NQRIRA) distributions that may be subject to taxation, a 10% penalty or both.

As mentioned, there are two ways for $$ to be stuffed into a RIRA: direct contributions (including roll overs of employer plan-designated-Roth salary deferral contributions) and conversion contributions. All RIRA contributions must, by definition, be after-tax (non-deductible), whether the Roth is a RIRA or designated part of an employer retirement plan. This means such an individual RIRA will have a 'basis' which will be the total of all past contributions. Unlike a TIRA with after-tax contribution basis where withdrawals are prorated between the basis and the untaxed total in the TIRA, NQRIRA withdrawals will come out contributions first. This is simply a return of these after-tax contributions, so there is no tax due and no 10% penalty.

TIRA to RIRA conversions may be made by any TIRA owner. Assuming the TIRA has no after-tax basis, all of the conversion amount will be ordinary income for the year of conversion. This conversion will remain ear-marked as a conversion within the RIRA until a full 5 years have elapsed OR the individual attains age 59 ½, whichever comes FIRST. Thus, if someone is age 59 1/2 or older, a TIRA-to-RIRA conversion will immediately form the basis and be added to existing basis. Once all of the RIRA's basis has been withdrawn, if there is a conversion that has not met the 5-year or age 59 ½ age test yet, it will be the next dollars that are withdrawn and will be subject to a 10% early withdrawal penalty unless an exception to the penalty exists (see below). Note that the conversion has already been subject to taxation in the year of conversion and so is not taxed again. If there is more than one conversion, each conversion will be treated separately with the oldest withdrawn first.

If the RIRA owner continues to withdraw after taking out the RIRA basis and any conversions, the next dollars to be withdrawn will be earnings… earnings from all sources within the RIRA, such as earnings from contributions, conversions, and existing earnings. Because these earnings have not yet been taxed, this portion of the NQRIRA withdrawal will be subject to taxation AND a 10% penalty, unless there is an exception to the 10% penalty.

The following are exceptions to the 10% early withdrawal penalty for taxable TIRAs and NQRIRA withdrawals:

Note that non-elective withdrawals such as a court judgment (some states), an IRS tax levy, and any earnings on withdrawn contributions will be subject to the 10% penalty unless one of the above exceptions exists.

Employer retirement plan designated Roth

"Designated Roth" plans that are part of an employer-sponsored salary deferral retirement plans, such as a 401(k)-Roth, a 403(b)-Roth and a government 457(b)-Roth, are becoming popular, particularly for higher income households whose MAGI is too high for contributions to an individual RIRA. Employer-sponsored designated Roths must be integrated with one of these salary deferral plans and cannot exist on its own. Designated Roth plans also allow for potentially much greater annual contribution amounts. For 2016, depending on plan contribution limits, it is possible for a worker to contribute up to $18,000 to their designated Roth plan plus another $6,000 if age 50 or older. The employee must be allowed to make this salary deferral contribution to either the pretax retirement plan (such as a 401(k)) or to the after-tax (non-deductible) Roth or to divide it between these two. The employer may not contribute to the Roth portion of the plan. It is important to note that a designated Roth plan is NOT a RIRA, and so will have some different rules.

  • Contributions to a designated Roth plan may not be recharacterized once made.
  • The requirements for qualified Roth withdrawals are the same for the employer plan designated Roth as for a RIRA. However, the 5-year holding period for a designated Roth will NOT transfer to the existing holding period of a RIRA but must remain on its own holding period timeline whether it is held in the employer plan or rolled over to a RIRA.
  • Elective withdrawals may not generally be made prior to separating from service, although the employer plan may allow for certain hardship withdrawals. If the 5-year holding period or age/disability/death requirements have not been met, any withdrawal will be non-qualified.
  • Non-qualified withdrawals from a designated Roth plan will be prorated between the total of all after-tax contributions and the value of the designated Roth. Non-qualified designated Roth withdrawals are not taken out basis first as happens with a RIRA.
  • Rollovers between designated Roth plans must be direct rollovers.
  • Indirect rollovers are treated as indirect rollovers for any qualified employer-sponsored retirement plan. The employer is required to withhold and send to the IRS as a withholding 20% of the value of the rollover. This 20% withholding may be made up "out of the pocket" of the employee. The full amount must be returned to the rolled over account within 60 days. Basis of the designated Roth may not be indirectly rolled to another employer-sponsored designated Roth but may be rolled to a RIRA of the owner.
  • The employer plan may allow for an 'in-plan' Roth rollover (conversion) of non-Roth plan balances to the Roth which will be treated as ordinary income for that year. Unlike a TIRA to RIRA conversion, these conversions may not be recharacterized and a distribution of any part of the conversion within 5 years will be subject to a 10% penalty.
  • Designated Roth plans may allow for employee loans. An IRA is never eligible for a loan, although a once-per-12 month period indirect rollover may be taken as a short-term loan providing the withdrawal is returned within 60 days.
  • If the designated Roth is left with the employer following separation from service, in the year the former employee attains age 70 ½ the employee must begin taking RMDs. So it is a generally a good idea for the retiring employee to roll over the designated Roth to a RIRA as soon as feasible.

A couple of examples will help to clarify these Roth rules:

Joe works for XYZ manufacturing as chief engineer, where his earnings have always exceeded the maximum allowable to contribute to a RIRA. So he was delighted when in 2006 his employer established a 401(k)-Roth, to which he has made the maximum allowable contribution to the Roth portion of the 401(k) each year since then. He has never done a TIRA to RIRA conversion. In 2016, at age 68, he will be retiring and has the following retirement plan balances:

Designated Roth plan balance: $400,000. $180,000 is contributions and $220,000 is account earnings.

401(k) plan balance: $500,000

TIRA balance: $200,000

Because he has held the designated Roth greater than 5 years and is over age 59 ½, withdrawals from his designated Roth will be qualified and not subject to taxation. In the year he attains age 70 ½ he will have to begin Required Minimum Distributions (RMDs) from his designated Roth, but because all withdrawals are qualified, the RMD will not change his tax bill. However, if he elects to rollover the entire designated Roth balance to his own RIRA, subsequent withdrawals will not be qualified. The rollover will constitute the basis of his new RIRA, from which the subsequent earnings will not be tax-free until he has held the RIRA for at least 5 years. Thus his withdrawals will be basis first, and as long as his subsequent total withdrawals do not exceed the basis during the first 5 years, he will not add to his taxable income. However, with about $700,000 in his TIRA, he will likely want to develop a withdrawal strategy that will include his TIRA to lessen the tax impact in 3 years at age 70 ½ when he must begin RMDs on his TIRA. A better strategy for Joe would be to have begun a RIRA with a small TIRA to RIRA conversion at least 5 years prior to his retirement so that when he did the direct rollover it would be to a qualified RIRA that had already met the 5-year holding period.

A second example involves inheriting a RIRA. Alice's widowed mother, age 68, did a $100,000 TIRA to RIRA conversion in 2013 as her first contribution to a RIRA. In 2015, Alice's mother died, naming her as the sole beneficiary of the RIRA (Alice, now age 45, is an only child). The value of the inherited RIRA at the end of 2015 was $125,000. As a non-spouse beneficiary, Alice has two choices in taking required distributions from the inherited RIRA (assuming the mother did not specify one of these methods to be used)

  1. 'Stretch' the minimum required withdrawals over her lifetime. Using Table I from Publication 590-B, Appendix B, Alice's life expectancy at the end of 2016 (the year following the year of death of the RIRA owner) is 38.8 years. Dividing this into the market value of the RIRA at the end of the year of death (2015) is 125,000/38.8 = $3,222 that must be withdrawn by 12/31/2016. Because Alice's mother died prior to holding any RIRA at least 5 years, the RMD is a NQRIRA withdrawal, but it is well within the $100,000 of the RIRA basis, as the conversion occurred after the owner, Alice's mother, attained age 59 ½ and as a NQRIRA withdrawal, basis is withdrawn first. Thus, the RMD, as basis, would not be subject to taxation. In 2017, Alice would have to do the same calculation, using the RIRA's value as of 12/31/2016 and a life expectancy of 38.8 - 1 = 37.8 years. In 2018 the 5-year holding period would be met and so all subsequent withdrawals will be qualified, meaning Alice could fully withdraw the RIRA balance, if she wished, without tax consequence.
  2. Alice could use the '5 year rule', as a RIRA has no Required Beginning Date for RMDs, as a TIRA has. This means that Alice could take any withdrawals she wished during any or all of the 5 years beginning with the year following the year of death, providing that all of the RIRA is fully withdrawn not later than 12/31/2020. So as long as Alice's withdrawals using this method do not exceed $100,000 for 2016 and 2017, all withdrawals in 2018 and beyond will be qualified and therefore will be tax-free.

Depending on Alice's cash flow needs, her best option would probably be the lifetime withdrawal method, as the inherited RIRA basis is large enough for her pre-QRIRA withdrawals to be a tax-free return of basis and all future earnings after 2017 will be tax-free to Alice, and she could withdraw as little as the RMD each year or more if she requires it, all tax-free. The worst option would be for Alice to simply withdraw the full RIRA balance in 2016/2017, as the earnings portion of the RIRA (about $25,000) would be taxable to Alice as ordinary income.

Conclusion

The RIRA began as a simple method of allowing middle and low income individuals to contribute a modest part of their employment income, after tax, to a long-term retirement plan that offers tax-free withdrawals during retirement years. But as is often the case, rules change and the added alternatives can make the RIRA a bit more complicated than its original form, for many. But understanding the fundamental rules of withdrawal are an important part of careful income planning for retirement years.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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