A client who wants to purchase a business asked our firm about the distribution rules for Roth IRAs. Seems he and his wife have Roth IRAs and would like to use the funds from those investments to purchase a business. So, what are the rules for Roth IRA distributions?
Qualified distributions from a Roth IRA are not included in the taxpayer’s income and they are not subject to the 10% penalty tax for early withdrawal. In order to be a qualified distribution, the Roth IRA distribution may not be made before the end of the five year period beginning with the first tax year the individual made a contribution to a Roth IRA. Important to note, each Roth IRA owner only has one five year period for all of the Roth IRAs that individual owns.
In addition to meeting the five-year holding period, a distribution will be considered a qualified distribution only if it is
• Made on or after the date on which the individual reaches the age of 59.5
• Made to a beneficiary (or the beneficiary’s estate) on or after the individual’s date of death
• Attributable to the owner being disabled
• A distribution to pay for qualified first-time homebuyer expenses, up to $10,000
If the above requirements are not met, the distribution is considered non-qualified. A portion of the distribution may be includible in gross income if the distribution is non-qualified. There are specific ordering rules to determine what amounts may be includible in gross income. Regular Roth contributions are deemed to be withdrawn first, then amounts transferred from traditional IRAs. Earnings are treated as withdrawals after contributions. So, no amount is includible in gross income until all of the after-tax contributions have been distributed.
In our client’s situation, he needed $55,000 to purchase the business. He is not over the age of 59.5, so the distribution will be non-qualified. His basis in his Roth IRA exceeds the $55,000 he needs to acquire the business, so he can take the distribution from his Roth IRA tax-free. Going forward, however, if he were to take another Roth IRA distribution, it would be taxable and, subject to the 10% early withdrawal penalty if he were still under age 59 1/2.