Definition and Examples
How Does a Qualified Distribution Work?
Qualified Distribution vs. Qualified Transfer
Definition and Examples
A qualified distribution allows you to avoid penalties and taxes on money withdrawn from a Roth retirement account. Although you contribute post-tax money to Roth accounts, the IRS has specific requirements, or “qualifications,” that you must meet in order to avoid paying taxes on withdrawals from such plans.
A qualified distribution is a withdrawal from a Roth IRA or designated Roth account that meets specific IRS requirements and incurs no taxes or penalties. Qualified withdrawals reduce the tax burden when taking distributions of earnings from a Roth account in retirement.
If your withdrawal does not qualify under IRS rules, taking earnings from your Roth account may subject that portion to regular income taxes and a 10% tax penalty if the withdrawal is made before you reach age 59½.
The basic IRS requirements for a qualified distribution are when the withdrawal is made:
- From a Roth account that has been open for at least five tax years, starting from the year you made your first contribution
- At age 59½ or older
- Due to disability
- Due to your death, whether by you or for your benefit
- Up to $10,000 to buy, build, or renovate your first home
Note: The five-year holding period begins on January 1 of the year in which any Roth account was contributed to.
Let’s say you opened a Roth IRA with a broker a decade ago and contributed the maximum allowed. Over that time, you made significant earnings on your contributions. At age 59½, you decided to withdraw your contributions and some of your earnings. Because you meet the account and age requirements, your Roth IRA withdrawal is considered a qualified distribution. Thus, you will not face an early withdrawal penalty or any taxes on the portion taken from earnings.
How Does a Qualified Distribution Work?
Roth retirement accounts you can utilize for qualified distributions include a Roth IRA and designated Roth accounts such as a Roth 401(k), Roth 403(b), a Roth thrift savings plan (TSP), and Roth 457. You can get a Roth IRA for yourself through a broker. On the other hand, a designated Roth account is an option for using post-tax dollars to contribute to a plan offered by your employer. These options will vary based on how the contributions are made and how you qualify to make them.
Note: Whether you have a Roth IRA or a designated Roth account, you have already paid income taxes on your contribution at your applicable tax rate. This means you do not get tax deferral as with traditional retirement accounts like a traditional IRA or 401(k).
However, the benefit is that you may be in a better position if your post-retirement tax rate is higher than the year you made the contribution. Additionally, it provides you with the ability to access your contributions in a Roth account without paying taxes, offering some comfort and peace of mind.
The rules for qualified distributions come into play when you withdraw earnings from your Roth account. Unless you meet IRS requirements for a qualified distribution, you will have to include the earnings – not the original contribution – when calculating gross income on your tax return. Therefore, you will have to pay your current tax rate on that amount. This can be especially harmful if you fall into a high tax bracket, where you have a lot of other income during that time.
Additionally
In addition to paying taxes on your profits, the IRS also requires a 10% additional tax for early withdrawals. However, an exception may apply where you only need to pay income taxes on the earnings, not the additional penalty.
For example, you can avoid the 10% penalty on earnings from a Roth IRA for:
- Qualified education expenses, health insurance while unemployed
- Personal medical expenses exceeding 7.5% of the adjusted gross income for that year
- Up to $10,000 for first-time home purchase
- Up to $5,000 for qualified adoption or birth
Note: Check your state tax laws to determine if they will impose any additional taxes on Roth plan withdrawals, especially if they are not qualified.
To understand how a qualified distribution affects your taxes, let’s assume you withdraw $5,000 from your Roth IRA. In this case, assume your Roth account has $4,500 in contributions and $500 in earnings. As long as you meet the criteria for a qualified distribution, you will not owe your current tax rate on the $500 in earnings. You may be subject to a 10% early withdrawal penalty depending on your age.
Qualified Distribution vs. Qualified Transfer
Qualified distribution from a Roth Qualified transfer
Withdrawing funds from your account Transferring funds to another account
Avoid penalties and taxes Taxes must be paid on funds that have not been taxed previously
IRS requirements must be met IRS rules must be followed
If you want to withdraw earnings because you simply need to move funds from one Roth account to another, consider a qualified transfer instead. This option allows you to move funds between two Roth IRAs or from one specific Roth account to another specific Roth account or Roth IRA. If you are transferring funds to a Roth IRA, you can transfer both taxable and non-taxable portions; otherwise, you can only transfer the taxable portion.
Note: You will need to pay taxes on any funds that have not been taxed previously and are transferred to a Roth account or a specific Roth account.
You can do this through a direct transfer, where you withdraw the funds and deposit them yourself in the new account. Alternatively, you can choose an indirect transfer, where the plan holder transfers the funds to the new account.
As long as you follow the IRS instructions for transfers, you can avoid the 10% penalty and taxes on the earnings. Specifically, you will have 60 days to place the withdrawn funds in the new account. Additionally, if you are transferring from one Roth IRA to another, you can only do it once a year. If you fail to meet these requirements, the IRS will treat the failed transfer as a Roth account distribution, subjecting your earnings to the usual tax treatment.
Key Takeaways
A qualified distribution comes from the Roth retirement account and must meet certain criteria to provide tax benefits. You can avoid paying taxes on the earnings of a Roth account and the additional 10% tax when you receive a qualified distribution. Key criteria include having the account for five years since the first contribution and reaching age 59½ or death or disability. You may qualify for an exemption from the 10% income tax even if your distribution is not qualified. A qualified transfer between Roth accounts can also be an alternative that avoids negative tax consequences.
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Sources:
Internal Revenue Service. “Publication 590-B – Distributions from Individual Retirement Accounts (IRAs),” page 31.
Internal Revenue Service. “Ten Differences Between Roth IRA and Roth Designated Account.”
Internal Revenue Service. “Publication 590-B – Distributions from Individual Retirement Accounts (IRAs),” page 32.
Capital Group, American Funds. “State Tax Withholding for Withdrawals on IRAs and Qualified Plans.”
Internal Revenue Service. “Conversion to Roth IRA or Roth Designated Account.”
Internal Revenue Service. “Topic No. 413 – Rollovers from Retirement Plans.”
Source: https://www.thebalancemoney.com/what-is-a-qualified-distribution-5225047
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