How to Dodge the Top 3 Roth IRA Tax Traps
The promise of tax-free distributions is one of the primary reasons why an individual might choose a Roth IRA over a traditional account. But ‘premature’ distributions could cause a Roth distribution to be taxable.
A Roth IRA comes with the promise of tax-free income to its owner and beneficiaries. However, if distributions are taken before the owner meets certain requirements, income taxes could be owed on the distribution amounts. This includes the 10% early distribution penalty (additional tax) that is owed on distributions taken before the account owner reaches age 59½.
These tax bills often come as a surprise to Roth IRA owners and beneficiaries who are unaware that they must meet certain eligibility requirements for their distributions to be completely tax-free.
Following are three examples.
1. 10% additional tax on conversion tax-withholding
Trap: Having income taxes withheld when requesting a Roth conversionmight subject the withholding amount to a 10% additional tax.
Distributions that are made from a traditional IRA before the owner reaches age 59½ are subject to a 10% additional tax, unless an exception applies. One of those exceptions is amounts converted to a Roth IRA (the Roth conversion exception). However, many IRA owners are not aware that amounts withheld for income taxes are not part of the conversion and therefore not eligible for the Roth conversion exception.
Example: Assume that John requested his $100,000 traditional IRA balance to be converted to a Roth IRA and elected to have 20% withheld for income taxes. Assume too that the entire amount is attributed to pretax assets and would therefore be fully taxable.
The results would be as follows:
- The custodian would remit $20,000 to the IRS as taxes withheld, and $80,000 would be deposited to the Roth IRA.
- The $80,000 would be taxable but would be exempted from the 10% additional tax.
- The $20,000 would be taxable, and would be subject to a $2,000 (10%) additional tax.
Consider too, that the amount withheld for income tax would not benefit from the tax-deferred (and potentially tax-free) growth available to the Roth IRA.
Solution: The IRA owner can avoid this 10% additional tax by paying the withholding tax with funds held outside of a retirement account.
2. Income tax on nonqualified distribution of earnings
Trap: Taking a distribution of earnings before being eligible for a qualified distribution will result in income taxes being owed on the amount.
A distribution from a Roth IRA is tax-free if it’s qualified. Such an amount is also not subject to the 10% early distribution penalty.
A Roth IRA distribution is qualified if it meets the following two requirements:
- It is made at least five years after the Roth IRA owner funded his/her first Roth IRA, and
- One of the following four applies:
- The Roth IRA owner is at least age 59½ at the time the distribution is made,
- The distribution is used to pay for qualified first-time homebuyer expenses. This is subject to a lifetime limit of $10,000,
- The distribution is attributable to the Roth IRA owner being disabled,
- The distribution is taken by the Roth IRA owner’s beneficiary, after the Roth IRA owner’s death.
A Roth IRA distribution that does not satisfy these two requirements is considered nonqualified and is subject to the ordering rules. Under the ordering rules, distributions from a Roth IRA are made from funding sources in the following order:
- From regular Roth IRA contributions first,
- Roth conversion amounts second, and
- Earnings last
If a nonqualified distribution includes earnings, the earnings amount would be subject to income tax. Further, if the distribution is made while the Roth IRA owner is under age 59½, the amount is also subject to a 10% additional tax unless an exception applies.
Example: 42-year-old Tina’s Roth IRA balance is comprised of:
- $50,000 in regular Roth IRA contributions
- $5,000 earnings
Tina is not eligible for a qualified distribution.
She takes distribution of her entire Roth IRA balance. The tax consequences are:
- $50,000 tax-free
- $5,000 taxable; and also subject to the 10% additional tax unless she qualifies for an exception.
Solution: If the IRA owner is not eligible for a qualified distribution, avoid taking distribution of amounts attributable to earnings.
3. Recapture tax on distribution of taxable conversion before 5 years
Trap: Taking a distribution of taxable conversion amounts before the 5-year period could result in the 10% additional tax.
As mentioned earlier, amounts converted to a Roth IRA are exempted from the 10% additional tax. But that 10% additional tax is recaptured if the amount is distributed before the conversion is aged five years.
For this purpose, distributions of conversion amounts occur on a first-in-first-out basis. It is important therefore, to keep track of conversion amounts by years, to easily determine whether an amount is subject to the 10% additional tax.
Example 1: Assume that 45-year-old Angela converted $100,000 to her Roth IRA in 2017, all of which was from pretax funds. Even though she is under age 59½, the conversion was not subject to the 10% early distribution penalty as it qualified for the Roth conversion exception.
Assume too, that the conversion is the only amount Angela ever added to a Roth IRA.
If Angela takes a distribution of $20,000 from her Roth IRA in 2018, the amount would be subject to a 10% additional tax (unless she qualifies for an exception), because the distribution occurred before the conversion aged five years in the Roth IRA.
Example 2: Assume that 55-year-old Tom converted the following amounts to his Roth IRA:
- $100,000 in 2014
- $50,000 in 2016
Assume too, that these conversions are the only amounts that Tom added to his Roth IRAs.
If Tom takes a distribution of $100,000 or less, it will come from the 2014 conversion first, and would be subject to a 10% additional tax, if the distribution occurs before January 1, 2019.
Distributions from the 2016 conversion will occur only after the $100,000 converted in 2014 is already distributed. Distributions from the 2016 conversion would be subject to a 10% additional tax, if the distribution occurs before January 1, 2021.
Solution: Keep track of Roth conversion amounts by year, to determine if a distribution would be taken from an amount that has been converted for less than five years. Where possible, avoid taking distributions from such amounts, unless an exception applies.
Penalty exception reminder
If distributions from a Roth IRA are nonqualified and occur before the Roth IRA owner reaches age 59½, the following should be considered:
- Distributions that are nontaxable are never subject to the 10% additional tax. This includes distributions of regular Roth IRA contributions, which—as explained above—occurs first under the ordering rules.
- Distributions from ‘nontaxable conversion’ amounts are never subject to the 10% additional tax. A nontaxable conversion would occur if the traditional IRA (or rollover from employer sponsored retirement plan) included basis (after-tax amounts).
Under the ordering rules, these amounts are considered distributed after-taxable conversion amounts.
For example: If an IRA owner converted $10,000 to a Roth IRA in 2012, which consisted of $8,000 pretax amount and $2,000 in basis, a distribution from the $10,000 would come from the $8,000 first and the $2,000 after.
- All of the exceptions to the 10% additional tax that applies to traditional IRAs, also apply to Roth IRAs. As such, one should check to determine whether a client qualifies for any of those exceptions.
Please see the included list of exceptions, which is broken down by type of retirement account.
Advance planning is recommended for tax efficiency
Roth IRAs help to provide the tax diversity that is often considered necessary for efficient retirement income planning. And, in an ideal world, distributions would not be taken from Roth accounts until the owner is eligible for qualified distributions.
But clients sometimes find themselves having no choice but to take premature and unplanned distributions from their retirement savings accounts, including their Roth IRAs.
Regardless of when a distribution occurs, advance distribution planning is often necessary to minimize any tax impact.
To that end, encourage clients to consult with you before requesting distributions from their Roth IRAs and other retirement accounts. You can help them determine if it is more tax efficient to use funds from sources other than IRAs in order to achieve maximum tax efficiency.
Securities offered through Securities Service Network, LLC. Member FINRA/SIPC. Advisory Services through SSN Advisory, Inc., a registered investment advisor.
