Optimizing Your Taxes with Roth IRA Distributions

By Baker Newman Noyes April 6, 2015

In 2010 the IRS eased restrictions on converting money held in Traditional IRAs to Roth IRAs and allowed for deferred tax payments on the conversion. For taxpayers who took advantage of this potentially significant tax savings opportunity, tax year 2015 is the end of a five-year waiting period for taking qualified, tax-free, penalty-free distributions from their Roth IRAs. To be a qualified distribution, the following requirements must be met.

1. It is made after the 5-year period beginning with the first taxable year for which a contribution was made or set up for your benefit, and
2. The distribution is:
   1. Made on or after the date you reach age 59 1/2,
   2. Made because you are disabled,
   3. Made to a beneficiary or to your estate after your death, or
   4. One that meets the requirements for an exception.

To take, or not to take, Roth distributions

The waiting period may be over, but that does not necessarily mean now is the right time to take Roth distributions. A broader strategy is needed, especially when a taxpayer has a mix of retirement accounts, such as a 401k, Traditional IRA, and Roth IRA. While taking distributions first from your 401k or Traditional IRA triggers a current tax liability, it also reduces the required minimum distributions (RMDs) in future years, thus smoothing out the tax impact of the distributions over time. At the same time, this strategy allows the Roth IRA to continue growing into a more sizable legacy for heirs.

Roth IRAs are not subject to RMDs during the owner’s lifetime, but beneficiaries are required to take RMDs under the same rules that apply to inherited IRAs, which includes the ability to stretch out the distributions in certain situations (explained in our previous article, What Happens to an Inherited IRA?). Roth IRA distributions to beneficiaries are tax-free just as they would have been to the original owner, so leaving a Roth IRA, compared to a Traditional IRA, for your heirs is a huge tax advantage for them, particularly if they are still in their working years and earning enough to put them in a relatively high tax bracket.

On the other hand, if you incur a larger than expected expense in a given year, it may make more sense to take a Roth IRA distribution to cover the costs. If you were to increase your distributions from taxable retirement plans instead, you may need to take out enough to cover the unexpected expenses plus the increased taxes, and it could push you into a higher tax bracket, increasing your overall tax burden (not to mention a possible increase to Medicare premiums). The one-time Roth distribution would be tax-free, as long as it is a qualified distribution, thus avoiding the collateral tax consequences of dipping deeper into taxable retirement pools.

Moreover, since qualified Roth distributions are not taxable and not included as part of your adjusted gross income, they likewise are not factored into the Net Investment Income Tax (NIIT) threshold calculation, whereas distributions from Traditional IRAs and qualified plans are (for more details about the NIIT, see our previous article, Two New Taxes on High-Income Individuals). Avoiding the NIIT may be another consideration when determining whether to withdraw from your Roth IRA or other sources. If, for example, you are a joint filer with adjusted gross income of $200,000 and you are planning to withdraw an additional $50,000 from retirement funds, you may consider withdrawing from your Roth IRA in order to stay below the $250,000 NIIT threshold and thus avoid an additional 3.8% tax on your investment income.

Nonqualified Roth IRA distributions

What are the tax consequences of taking a nonqualified Roth IRA distribution? To the extent the distribution is a return of original contributions, there is no tax liability and no penalty. You will, however, pay income tax and a 10% penalty on all earnings withdrawn.

Summary

As discussed, the major advantage of Roth IRAs, when the rules are followed, is tax-free growth as compared with tax-deferred growth in Traditional IRAs. The trade-off, however, is that there is no upfront deduction, thus no immediate tax savings. Indeed, taxpayers who took advantage of the relaxed Roth IRA rules back in 2010, likely did so with long-term goals in mind because the conversion from Traditional IRA to Roth IRA meant paying a current tax liability triggered by the conversion. Ultimately, there are many factors to consider, and the way to attain the greatest benefit from Roth IRAs is to maximize the time available for tax-free growth by delaying withdrawals as long as possible.

If you would like to discuss further, please call your BNN tax advisor at 1.800.244.7444.