Roth IRAs and Taxes: Contributions, Rollovers, Distributions

A “qualified rollover contribution” is any rollover contribution to a Roth IRA from a traditional IRA or other eligible retirement plan that meets the requirements of IRC Section 408(d)(3).  A rollover or conversion of a traditional IRA to a Roth IRA does not count in applying the one IRA-to-IRA rollover in any twelve month period limit.

For years prior to 2010, the taxpayer’s AGI was calculated without regard to the exclusions for foreign earned income, qualified adoption expenses paid by the employer, and interest on qualified United States savings bonds used to pay higher education expenses. Deductible contributions to a traditional IRA also were not taken into account in determining AGI. Amounts included in gross income as a result of a rollover or conversion from a traditional IRA or other eligible retirement plan to a Roth IRA were not taken into account. Social Security benefits includable in gross income under IRC Section 86 and losses or gains on passive investments under IRC Section 469 were taken into account. The definition of AGI excludes minimum required distributions to IRA owners aged 70½ or older, solely for purposes of determining eligibility to convert a regular IRA to a Roth IRA.

An eligible retirement plan, for this purpose, includes a qualified retirement plan, an IRC Section 403(b) tax sheltered annuity, or an eligible IRC Section 457 governmental plan. Taxpayers, including plan beneficiaries, can directly transfer (and thereby convert) money from these plans into a Roth IRA without the need for a conduit traditional IRA. (Other than by direct conversion from an eligible non-IRA retirement plan, a beneficiary may not convert to a Roth IRA.)

Planning Point: Major reasons for converting to a Roth IRA often include obtaining tax-free qualified distributions from the Roth IRA and greater stretch from the Roth IRA because distributions from a Roth IRA are not required until after the death of the owner (or the death of the IRA owner’s spouse if the spouse is the sole designated beneficiary and elects to treat the IRA as the spouse’s own), rather than starting at age 70½. A conversion also may make sense if it is expected that tax rates will increase (from the time of conversion to the time of distribution), but not if tax rates will decrease. Consider whether any special tax benefits, such as net unrealized appreciation, would be lost if a qualified plan is converted to a Roth IRA. Also, a qualified plan may offer better asset protection than a Roth IRA. State laws vary on this issue. If a taxpayer cannot qualify under the Roth AGI limitations, perhaps he or she can establish a traditional IRA, and then convert that into a Roth IRA. Note that this, however, has not yet been addressed by the IRS.

Q: How are amounts distributed from a Roth IRA taxed?

Where a Roth IRA contains both contributions and conversion amounts, there are ordering rules that apply in determining which amounts are withdrawn. In applying the ordering rules, traditional IRAs are not aggregated with Roth IRAs. All Roth IRAs are aggregated with each other. Regular Roth IRA contributions are deemed to be withdrawn first, then converted amounts second (in order if there has been more than one conversion). Withdrawals of converted amounts are treated first as coming from converted amounts that were includable in income. The ordering rules continue to treat earnings as being withdrawn after contributions.

“Qualified distributions” from a Roth IRA are not includable in gross income. Thus, earnings are tax-free, not tax deferred as with traditional IRAs. A “qualified distribution” is any distribution made after the five-taxable year period beginning with the first taxable year for which the individual made a contribution to a Roth IRA (or such individual’s spouse made a contribution to a Roth IRA) established for such individual and such distribution meets one of the following requirements.

(1) It is made on or after the date on which the individual attains age 59½;

(2) It is made to a beneficiary (or to the estate of the individual) on or after the death of the individual;

(3) It is attributable to the individual’s being disabled (within the meaning of IRC Section 72(m)(7));

(4) It is a “qualified first-time homebuyer distribution” (see below).

A “qualified first-time homebuyer distribution” is any payment or distribution that is used within 120 days after the day it was received by the individual to pay the qualified acquisition costs of a principal residence of a first-time homebuyer. The aggregate amount of payments or distributions received by an individual from all Roth and traditional IRAs that may be treated as qualified first-time homebuyer distributions is limited to a lifetime maximum of $10,000. The first-time homebuyer may be the individual, his or her spouse, any child, grandchild, or ancestor of the individual or his or her spouse. A first-time homebuyer is further defined as an individual (and, if married, such individual’s spouse) who has had no present ownership interest in a principal residence during the two year period ending on the date of acquisition of the residence for which the distribution is being made. The date of acquisition is the date on which a binding contract to acquire the residence is entered into or the date construction or reconstruction of the residence begins. Qualified acquisition costs are defined as the costs of acquiring, constructing, or reconstructing a residence, including reasonable settlement, financing, or other closing costs.

In calculating the five-taxable-year period, it is important to remember that contributions to Roth IRAs, as with traditional IRAs, may be made as late as the due date for filing the individual’s tax return for the year (without extensions). Thus, if a contribution is made to a Roth IRA between January 1, 2013 and April 15, 2014 for the 2013 taxable year, the five-taxable-year holding period begins to run in 2013.

For purposes of determining whether a distribution from a Roth IRA that is allocable to a “qualified rollover contribution” from a traditional IRA is a “qualified distribution,” the five-taxable-year period begins with the taxable year for which the conversion applies. A subsequent conversion will not start the running of a new five-taxable-year period.

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