Distributions from Roth Accounts: Qualified Distributions, Taxes, and Penalties

This post is part of a series about Roth accounts in general and Roth conversions in particular. Use these links to go to the other posts:

• Basics of Roth Conversions
• Converting to a Roth IRA: Factors to Consider
• Future posts will discuss when you can take distributions from Roth accounts, Required Minimum Distributions, and exceptions to the 10% early distribution penalty.

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There are usually two pots of money in a Roth account: contributions and earnings. When you convert money from a traditional (tax-deferred) account and move it into a Roth account, you have three pots of money: contributions, conversions, and earnings. If you made more than one conversion, each one is in its own little separate pot inside the conversions pot.

Each pot of money has different rules to determine its treatment for taxes and penalties. While contributions are always tax- and penalty-free when distributed, earnings may be subject to both taxes and penalties, and conversions can be subject to penalties. As a result, one critical question when you take a distribution from a Roth account is, from which pot or pots of money is the distribution coming?

How does this work? Keep reading!

Qualified Distributions, Taxes and Penalties

How are the different pots of money treated regarding taxes and penalties?

• Contributions are never subject to tax or penalty.
• Earnings will be tax-free and penalty-free if they are Qualified Distributions.
  • If they aren’t Qualified Distributions, they will be subject to tax. Period. However, they can still avoid the 10% early distribution penalty if they meet one of the exceptions. (Watch for a future post dedicated to those exceptions.)
• Conversions are never subject to tax. They can also avoid the early distribution penalty in three different ways:
  • They are a Qualified Distribution.
  • They were non-deductible contributions to the tax-deferred account from which they were converted and were therefore not taxable income upon conversion.
  • They meet one of the exceptions to the 10% early distribution penalty.

The following  information on Qualified Distributions was included in the earlier post, Basics of Roth Conversions, but I’m repeating it here to save you the effort of flipping back to that post.

Qualified distributions must meet a two-pronged test, which differs slightly for Roth IRAs and Designated Roth Accounts:

• Part 1: The 5-year rule
  • Roth IRAs:
    • For contributions and earnings, the five years begin on January 1 of the year you first made a contribution to any Roth IRA – not necessarily the one from which you are taking the distribution.
    • Each conversion has its own 5-year clock, which starts at the beginning of the tax year (January 1) in which that particular conversion was made.
  • Designated Roth Accounts: The five-year period is calculated separately for each Roth account and begins on the first day of the tax-year for which you made Designated Roth contributions to the plan, typically January 1.
    • If money is rolled from one Designated Roth account into another, the earlier start date between the two accounts applies.
• Part 2: The distribution is made either
  • On or after the date you reach age 59½,
  • Because you are disabled, or
  • To a beneficiary or to your estate after your death.
  • Roth IRAs only: For first-time home-buyer expenses, up to a $10,000 lifetime limit.

Distributions from a Roth IRA

Distributions from Roth IRAs are taken out in a specific order: contributions first, conversions next (if any; from oldest conversion to the most recent, if more than one), and finally earnings. This rule is unique to Roth IRAs, and it is very favorable to the taxpayer: you will automatically be subject to the least possible amount of tax and penalties – if any – and they will be delayed as long as possible.

For example, say you have a $20,000 Roth IRA which you opened in 2011. It is made up of:

• Contributions: $10,000
• Conversions made in 2015 on which you paid income tax*: $5,000
• Earnings: $5,000

You take the following distributions:

• In 2017 at age 54, you withdraw $10,000. It all comes from contributions, so there is no tax and no early distribution penalty, even though it is not a qualified distribution. There are never taxes or penalties on distributions of contributions.   
• In 2023 at age 60, you withdraw another $5000, which all comes from conversions. There is no tax, because you already paid tax when you did the conversion. And because this is a qualified distribution (made more than 5 years after the conversion and after age 59 ½), there is no 10% penalty tax.
• At retirement in 2028, you begin to take additional distributions from the account. Only earnings are left in the account. Because these are qualified distribution (made more than 5 years after you opened your first Roth IRA account and after age 59 ½), there is no tax and no 10% penalty tax.

This is one of the reasons that Roth IRAs may be a more appealing way for younger workers to save for retirement. If sometime in the next 40 years between now and retirement they have a desperate need for cash, they can take out every dollar of their contributions without tax or penalty. There are no barriers to accessing the money – other than the fact that the money won’t be there when they retire. But earnings are only distributed after all contributions have been withdrawn, and only then will taxes and penalties even be a possibility.

Distributions from a Designated Roth Account

When an employer retirement plan such as a 401(k), 403(b), or 457 offers a Roth option, it is referred to as a Designated Roth Account, or sometimes a Deemed Roth Account.   Distributions from these accounts follow a different rule compared to Roth IRA. Distributions from an employer plan are regarded as a mixture of contributions, conversions, and earnings in the same proportion as in the account. It is sometimes called the “cream in the coffee” rule: once the funds are comingled, you can not separate one from the other.  

This makes it harder to avoid taxes or penalties, compared to distributions from a Roth IRA.  

If you had taken the same pattern of distributions from a Designated Roth Account in your 401(k), the result would be completely different.

Say you once again have $20,000, but this is a Designated Roth Account in your 401(k). You first made contributions to the account in 2011. It is made up of:

• Contributions: $10,000
• Conversions made in 2015, on which you paid income tax*: $5,000
• Earnings: $5,000

You take the following distributions:

• In 2017 at age 54, you withdraw $10,000. It is deemed to be 50% from contributions, 25% from conversions, and 25% from earnings.
  • The account has existed for more than 5 years but this is not a qualified distribution because you are not age 59 ½, disabled, or deceased. Assuming you do not qualify for any of the exceptions for the 10% early distribution penalty, you owe the penalty on both the conversions and the earnings that were distributed: ($5000 + $5000) X 10% = $1000.   
• In 2023 at age 60, you withdraw another $5000: $2500 comes from contributions, $1250 from conversions, and $1250 from earnings (For simplicity, we will ignore earnings that accumulated after the initial distribution in 2017.)
  • Because this is a qualified distribution, made more than 5 years after the account was opened and after age 59 ½, there is no tax and no penalty on the conversions or earnings.
• At retirement in 2028, you withdraw another $5000: $2500 comes from contributions, $1250 from conversions, and $1250 from earnings (For simplicity, we again will ignore earnings that accumulated after the initial distribution in 2017.)
  • Because this is a qualified distribution, made more than 5 years after the account was and after age 59 ½, there is no tax and no penalty on the conversions or earnings.

There are tons of rules for Designated Roth Accounts. A very complete and well-organized list of information is the IRS Retirement Plans FAQs on Designated Roth Accounts.

Coming soon:

Watch for posts covering all those exceptions to the 10% early distribution penalty, RMDs, and in-service distributions