Qualified vs. Nonqualified Roth IRA Distributions

Published on June 16, 2022

Traditional and Roth IRAs – which can both be self-directed – help individuals to build retirement wealth. However, these retirement plans handle contributions and withdrawals differently:

• In a Traditional IRA, the funds grow tax-deferred, meaning the account owner pays taxes on the withdrawals, but not the contributions; the contribution amount may be fully or partially tax deductible.
• In a Roth IRA, the contributions are taxed going in and the earnings grow tax free, meaning the account owner does not pay taxes on the distributions—so long as they are qualified (as explained below).

The Roth IRA’s tax-free distribution status is applicable only when the distribution be considered “qualified”; otherwise, the account owner will pay tax on the amount. We break down what makes a Roth IRA distribution qualified or non-qualified here.

Qualified Roth IRA distributions

A qualified Roth distribution means that two conditions have been met:

1. Five-year waiting period – the Roth IRA owner’s first contribution (including a Roth conversion) was at least five years ago. This waiting period begins on the first day of the taxable year in which the contribution was made.
2. Age, disability, death, or first-time homebuyer – the Roth IRA owner is at least 59 ½ years old, has become permanently disabled, has died (and a beneficiary or the estate takes a distribution), or funds will be used to buy, build, or rebuild a first home (up to $10,000 maximum).

Both conditions must apply for the distribution to be tax and/or penalty free. However, the account owner can withdraw his or her contribution amounts any time, regardless of age, without paying taxes or penalties (this exception does not apply to earnings).

Nonqualified Roth IRA distributions

If a distribution is taken before the five-year waiting period is over or one of the qualifying reasons noted in #2 above is not met, the Roth IRA distribution is considered nonqualified. In that case, doing so may trigger a taxable event and/or withdrawal penalty.

This is also “legislated” by a set of rules called Roth IRA ordering rules. These rules govern account contributions, earnings, and distributions and determine the taxes and penalties of nonqualified distributions (they are outlined in IRS Publication 590-B and Form 8606).

The ordering rules dictate the order in which Roth IRA assets are to be distributed, which is as follows:

First: regular contributions. These are not subject to tax or a penalty tax because they were taxed going in.

Second: conversions and retirement plan rollover assets. These funds are distributed by year, with taxable assets distributed before nontaxable assets (based on the separate five-year waiting periods):

• Any taxable conversion or retirement plan rollover that is distributed before that five-year period is met incurs a 10% early distribution penalty tax.
• In the case of a Roth conversion, the five-year clock starts on January 1 of the year the conversion was made. For inherited Roth IRAs, it begins when the original owner made the first contribution.
• The account owner may qualify for a penalty exception (detailed below).

Third: earnings on contributions and conversions, aggregated.  Any earnings on a nonqualified distribution are taxed as ordinary income and may be subject to penalty tax unless an exception applies.

Exceptions to the 10% penalty

Roth IRA account owners may avoid paying the 10% penalty on what would otherwise be a nonqualified distribution if they meet one of these withdrawal reasons:

• To cover the cost of childbirth or adoption (up to $5000)
• To pay for qualified education expenses
• To pay for a qualified disaster recovery matter
• Due to an IRS levy
• Medical insurance premiums after losing a job, or unreimbursed medical expenses that exceed 10% of your adjusted gross income
• Qualified reservist distribution
• A series of substantially equal distributions

As with all things related to one’s retirement plan and personal finances, the team at Next Generation encourages account owners to consult their trusted advisors for guidance on these rules and requirements.

Self-directed Roth IRAs

An individual can open a self-directed Roth IRA to have full control over the investments within the account. Contribution limits and distribution rules are the same as with Roth IRAs that are not self-directed. At Next Generation, we are happy to answer your questions about self-directing your retirement plan, and about the many alternative assets allowed within a self-directed IRA of any type. You may set up a complimentary educational session with one of our knowledgeable representatives or contact our team directly via email at NewAccounts@NextGenerationTrust.com or call (888) 857-8058. Alternatively, you can also text us from your mobile phone using the number (848) 233-4076.