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Dodge the tax bullet on ‘taxable’ Roth distributions

by on
in Small Business Tax

All the buzz about Roth IRAs in 2010 is about the new rules for conversions. For the first time ever, you can convert a traditional IRA to a Roth, regardless of your annual income. Previously, conversions weren’t allowed for taxpayers with a modified adjusted gross income (MAGI) over $100,000.

But nothing has changed in the rules for Roth IRA distributions. Unless payouts of accumulated Roth account earnings meet the definition of “qualified distributions,” they are subject to tax.

Strategy: Minimize the tax burden when you withdraw from a Roth. Despite the common perception, the tax owed on distributions may be less than you think. In fact, some distributions are tax-free!

The exact tax treatment depends on the “ordering rules” for Roth IRA distributions.

Here’s the whole story: Unlike traditional IRAs, participants in a Roth IRA aren’t required to take required minimum distributions (RMDs) after reaching age 70½. But they can choose to take withdrawals whenever they wish. If the withdrawal includes earnings and meets the requirements for a qualified distribution, it is 100% exempt from tax.

A qualified distribution is one that is made from a Roth IRA in existence for at least five years after the account owner has reached age 59½, upon death or disability, or used to pay first-time homebuyer expenses (up to a lifetime limit of $10,000).

All other distributions are treated as nonqualified distributions. Nonqualified distributions (e.g., distributions that are received prior to reaching age 59½) are treated as coming from a Roth IRA account balance in the following order:

1. Regular annual Roth IRA contributions. These can be taken out tax-free even if they are nonqualified.

2. Contributions from converting taxable traditional IRA balances into Roth status (which we’ll call “taxable conversion contributions”). These can be taken out tax-free even if they are nonqualified, but a 10% penalty tax generally applies to withdrawals within five years, unless you’re age 59½ or older.

3. Contributions from converting nontaxable traditional IRA balances into Roth IRA status
(called “nontaxable conversion contributions”). These can be taken out tax-free even if they are nonqualified.

4. Earnings that accumulated within the Roth IRA
(i.e., “Roth IRA earnings”). These amounts are taxable when withdrawn unless they met the definition of qualified distributions. In addition, a 10% penalty tax may apply to nonqualified withdrawals before age 59½.

Because distributions are treated as coming first from Roth contributions, you may be able to take out as much as you put in—at any time—without tax consequences.

Example 1: You’re currently age 60 and you established a Roth IRA in 2007. You contributed $4,000 for 2007, $5,000 for 2008 and $5,000 for 2009. The account is currently valued at $15,000, consisting of $14,000 in contributions and $1,000 in earnings.

In 2010, you withdraw $10,000 from the Roth. The $10,000 withdrawal is treated as coming out of the $14,000 in contributions, so you owe no tax on the distribution.

When you take a distribution from a Roth IRA, the tax calculation is based on the assets in all of your Roth IRAs. The taxable portion of the distribution is also subject to a 10% penalty tax unless one of the special exceptions for early withdrawals applies.

Example 2:
Let’s change the facts slightly. You’re currently age 55 and you established a Roth IRA in 1998. Over the years, you’ve contributed $15,000 to the Roth and have $10,000 in earnings. In addition, you established a second Roth in 2008. You’ve contributed $4,000 to the second Roth and have $1,000 in earnings. The total value of your Roth assets is $30,000.

In 2010, you withdraw the entire $25,000 in the first Roth. Because $19,000 of the distribution is treated as coming from contributions to both of your Roth IRAs, you’re taxed on only $6,000 of the distribution. If you’re in the 25% tax bracket, you owe tax of $1,500 (25% of $6,000), plus a tax penalty of $600 (10% of $6,000), for a total of $2,100 ($1,500 + $600).

The point is: The tax liability for a nonqualified distribution may be much less than you fear, even if you have to pay the early withdrawal penalty.

On the other hand, a participant can’t reduce tax liability by withdrawing funds from a Roth stocked with contributions as opposed to with one brimming with earnings. Remember: The calculation takes all of your Roth IRAs into account.

There may be complications when you have one or more Roth accounts with conversion contributions (see box below).

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