Answers to Your Roth IRA Questions

I appreciate the feedback I received on my article Is Your Roth IRA Distribution Taxable? As promised, I will address some of the questions you submitted about the taxability of Roth IRA distributions.

Start of Five-Year Rule

Question: “I appreciated Denise’s article, but I believe it does not address a particular situation: Imagine that an employee regularly contributes to his employer-provided Roth 401(k) for three years. Upon turning age 65, this employee retires and rolls over the Roth 401(k) to his Roth IRA. When does the five-year period commence?”

Answer: The five-year period for a qualified distribution from the Roth IRA starts when he made the first contribution or conversion to a Roth IRA. For example, if the Roth 401(k) in your scenario was rolled over in 2023 and that rollover was the first time he funded a Roth IRA, the five-year period used to determine if his Roth IRA distribution is qualified starts Jan. 1, 2023.

The years for which the Roth 401(k) was funded do not count as part of the Roth IRA five-year rule.

Let’s look at another example: 57-year-old Tyrone had a Roth 401(k) under his former employer’s 401(k) plan, to which he made contributions for 10 years.

His employment was terminated in 2023.

Tyrone established a Roth IRA in 2023, to which he rolled over his Roth 401(k) as a direct rollover. His Roth 401(k) balance at the time of the rollover was $50,000, $10,000 of which were earnings.

This rollover is the first time Tyrone has ever funded a Roth IRA.

Tyrone was not eligible for a qualified distribution from his Roth 401(k).

Note:

• Tyrone’s five-year period for a qualified distribution from a Roth IRA starts Jan. 1, 2023.
• A distribution from a Roth 401(k) is qualified if the Roth 401(k) account has been funded for at least five years and the participant was age 59 1/2, disabled, or dead at the time the distribution was made. Tyrone did not meet both requirements, which makes his Roth 401(k) distribution nonqualified.
• Because Tyrone’s distribution from his Roth 401(k) is nonqualified, it is allocated to his Roth IRA as $40,000 basis (Layer 1) and $10,000 earnings (Layer 3).
• The Roth IRA ordering rules will apply if Tyrone takes a distribution from his Roth IRA before 2028. Distributions during 2028 and after would be qualified because by then he would have funded a Roth IRA for at least five years and would meet the age 59 ½ requirement.

Qualifying Distributions

Question: “In the example: 45-year-old Tara converted $75,000 from her traditional IRA to her Roth IRA in 2018 and $25,000 from her SEP IRA to her Roth IRA in 2018. This is a total of $100,000 for 2018.

Scenario 1 is clear.

But Scenario 2 is:

If Tara distributes the $100,000 and the $50,000 in 2024, only the $50,000 would be subject to the 10% early distribution penalty because it would not have been at least five years since it was converted to her Roth IRA. The 10% early distribution penalty would be waived if Tara qualifies for an exemption.

This seems to contradict what was explained earlier, that once the five-year clock starts, it is not reset. Careful reading of the earlier parts of the article leads me to believe that it is not the five-year rule that makes it taxable, but the fact that Tara is under 59 ½ and this is a rollover contribution. Is that correct?”

Answer: You are correct that “once the five-year clock starts, it is not reset.” However, that rule applies only to the five-year clock that is used to determine whether a Roth IRA distribution is qualified. In my article, see “Step 1: Determine if the Roth IRA Distribution Is Qualified.”

Tara’s distribution is nonqualified because she is under age 59 ½ and not disabled, and therefore, “Five-Year Rule Number One” does not apply. We must then go to “Step 2: Apply the Ordering Rules for Nonqualified Distributions.”

Under the ordering rules, “Five-Year Rule Number Two” applies to Tara’s qualified rollover contributions. For qualified rollover contributions, a new clock for “Five-Year Rule Number Two” starts each year a qualified rollover contribution is made.

For Tara’s example, in both Scenario 1 and Scenario 2, the five-year clock for “Five-Year Rule Number Two” applies as follows:

• Her $100,000 conversion done in 2018 has a five-year clock that starts Jan. 1, 2018. Any distribution taken from this $100,000 before 2023 will be subject to the 10% additional tax unless she qualifies for an exception.
• Her $50,000 was converted in 2023 and has a five-year clock that starts Jan. 1, 2023. Any distribution from this $50,000 before 2028 will be subject to the 10% additional tax unless she qualifies for an exception.

Please see my 2023 Quick Reference Guide for: Roth IRA Distribution Tax and Penalty Determination (free download) for an explanation of how rollovers are allocated to a Roth IRA.

Tip: Tara must keep track of the sources of her Roth IRA assets until 1) she has funded any Roth IRA for at least five years and 2) she is either age 59 ½ or disabled. Once she has met these two requirements, the ordering rules do not apply because all her Roth IRA distributions would be tax-free.

States Have Different Rules

Question: “New Jersey taxes a nonqualified Roth IRA distribution on a pro rata basis. This makes a portion of a nonqualified distribution always taxable if the Roth IRA has earnings. This is different from federal tax treatment, which applies the ordering rules, as you explained. How does a taxpayer resolve this discrepancy?”

Answer: In cases where a state treats IRA distributions differently from the federal tax rules, a taxpayer must follow each set of rules for each tax return. This means that an amount that is tax-free at the federal tax level might not be tax-free at the state level and vice versa.

The following is an example:

John’s total Roth IRA balance is $20,000, $2,000 of which is earnings and $18,000 is from regular Roth IRA contributions. John lives in New Jersey, where the pro rata tax treatment applies to nonqualified Roth IRA distributions.

Assume John takes a nonqualified distribution of $10,000. The tax treatment would be as follows:

Federal Tax Treatment

Under the ordering rules, the $10,000 is tax-free (no income tax, no 10% additional tax) because it is from Layer 1.

New Jersey Tax Treatment

$9,000 is from Layer 1 and is tax-free; $1,000 is from Layer 3 and taxable.

But caution: Taxpayers should consult with their CPA or other tax professional to determine if there are exceptions to this rule under federal and state law. For example, under federal law, the $1,000 earnings would be included in the $10,000 for qualified charitable distributions but would be excluded from income (under QCD rules).

Detailed Roth Records Are a Must

These questions prove that determining the taxability of a Roth IRA distribution is complex. Fortunately, a Roth IRA custodian will report a distribution as qualified if they know it meets the five-year rule and the owner is at least 59 ½ or disabled when the distribution is made. But in other cases, the responsibility for showing the IRS how much is taxable rests with the Roth IRA owner.

To avoid paying income tax on tax-free amounts, Roth IRA owners must keep records of their Roth IRA contributions, conversions, and distributions just in case it becomes necessary to prove that a distribution is tax-free or exempt from the 10% early distribution penalty.