Taking Qualified Roth IRA Distributions - Eligibility & Examples

(March 15th, 2008)

Any 'qualified distributions' you take from a Roth IRA will NOT be included in your taxable income, hence making you exempt from paying taxes. You won't have to pay taxes on the original principal you contributed nor any taxes on capital gains & earnings you have accumulated. Pretty sweet you think for Roth IRAs, eh? In order for the distribution to be classified as 'qualified', it must be taken under 1 of the following circumstances:

- the Roth IRA investor must be 59 and 1/2 years or older at the time of the distribution
- the Roth IRA investor becomes disabled at the time of taking the distributions
- the Roth IRA investor dies and his/her beneficiary receives the assets contained in the plan
- the distributions taken from the Roth IRA will be used in the purchase or building of a new home for the Roth IRA holder or qualified family member. This is limited to $10,000 per person per lifetime. Qualified family members include:
--> the Roth IRA investor
--> the Roth IRA investor's spouse
--> children of the Roth IRA investor
--> grandchildren of the Roth IRA investor
--> parent or ancestor of the Roth IRA investor

Note: Even if one of the above prerequisites is met, the Roth IRA must be atleast 5 years old before any distributions can be taken. This is a very important point to consider. For example if you set up your Roth IRA in March 22nd, 2003, you cannot take any distributions, even if they are qualified, until March 22nd, 2008. If you do, this distribution will not be qualified and you will have to pay the 10% early withdrawal penalty as well as income taxes. A few examples to illustrate these concepts would be useful. Here they are.

Example #1

Jim makes Roth IRA contribution on March 1st, 2002 for $3000. 6 years later on March 1st, 2008, Jim withdraws $5500 from his account (the principal $3000 + $2500 earnings). Jim's withdrawal is not qualified because he does not plan to purchase a home for the first time, nor is he disabled, plus Jim is not 59 and 1/2 years old or more. Jim will face a 10% early withdrawal penalty + have to pay income taxes on his withdrawal. If Jim had withdrawn only $3000 from his Roth IRA which equals the total contributions he made, he would not be subject to income taxes nor the 10% early withdrawal penalty. This is because Roth IRAs allow you to withdraw up to the maximum contributions you have made and not any earnings on those contributions. Since withdrew the whole $5500 consisting of $3000 principal + $2500 earnings, he will be penalized.

Example #2

Rishi who is 58 years old makes a $3500 contribution to his Roth IRA on April 12th, 1999 for the tax year 1998. On February 5th, 2003, Rishi withdraws $6000 from his Roth IRA consisting of $3500 original principal + $2500 earnings. At this time, Rishi is 62 years old. Will this distribution be treated as 'qualified'? You bet it is! This is because the 5 year waiting rule has passed. Even though Rishi made his contribution on April 12th, 1999, this contribution was designated for the tax year 1998. Thus from 1998 - February 5th, 2003, the 5 year waiting rule is met. As you can see from here, it is not necessarily the calender years that count; it is when the first contribution was made and for what year it was designated. Also, Rishi is 62 years old which meets the 59 and 1/2 year old requirement. Thus this distribution of $6000 will not be included in Rishi's taxable income.

Example #3

Donald who is 57 years old converts $2000 from his traditional IRA to his Roth IRA on February 15th, 1999. His 5 year waiting rule starts from Feb 15th, 1999. Donald makes the following contributions for these tax years:

On January 21st, 2004, Donald takes out all of his money from his Roth IRA valued at $18000 ($12,000 principal + $6000 earnings). Is this distribution qualified? Yes! First Donald will be 62 years old on that date, thus meeting the 59 and 1/2 year old requirement. Second, his 5 year waiting period ended on December 31st, 2003 after which he took the full distribution. Thus, this entire distribution is not taxable!