Early withdrawals from Roth IRAs are deceptively complex.

The Taxpayer Relief Act of 1997 (TRA '97), enacted on Aug. 5, 1997, added several new types of IRA alternatives. Dubbed the "American Dream" IRA, the Roth IRA has become the most highly publicized of all these new alternatives. On the surface, it seems fairly simple. Contributions to a Roth IRA are nondeductible; five years after the account is established and if the owner is at least 59 1/2 years old, withdrawals are tax-free. If, however, the owner of the Roth IRA needs to make an early withdrawal from the account, the provisions can become deceptively complex.

Two types of distributions can be made from a Roth IRA, qualified and nonqualified. Distributions must meet two sets of rules before they can be considered qualified. First, distributions must meet one of the exceptions set forth in Sec. 72(t)(2), which are applicable to distributions from a regular IRA. Even if one of these exceptions is met, the distribution is still not qualified if it is made within the five-year period beginning with the first tax year for which (1) the individual made a contribution to a Roth IRA or (2) a qualified rollover contribution from a regular IRA (a conversion contribution) was made. When multiple rollovers are maintained in a single account, the five-year rule for regular IRA rollovers is based on the latest rollover date. Under a technical correction in the IRS Restructuring and Reform Bill of 1998, the separate five-year period for a conversion contribution would be eliminated. Qualified distributions are not included in the taxpayer's gross income and are not subject to the additional 10% early withdrawal tax under Sec. 72(t).

Distributions that do not meet the requirements for qualified distributions are nonqualified and are taxed under the Sec. 72 annuity rules. In applying Sec. 72 to nonqualified distributions, if the distributions, when added to all previous distributions from the IRA account, do not exceed the aggregate amount of contributions to the account, they are treated as made from contributions. In addition, all of an individual's Roth IRA accounts are aggregated for this purpose. Distributions received from contributions are nontaxable (because contributions to a Roth IRA are nondeductible). Distributions in excess of the contributions are from the earnings on the contributions and included in the taxpayer's gross income. Under the technical corrections, distributions of a 1998 conversion contribution would be nontaxable. However, a distribution prior to inclusion of the full deferral amount in income would force an acceleration of amounts previously untaxed.

Nonqualifying distributions from a Roth IRA are not exempt from the early withdrawal penalty. The early withdrawal penalty is 10% of the distribution required to be included in the taxpayer's gross income. The early withdrawal penalty is in addition to the tax and imposed on nonqualifying distributions made before the individual has reached age 59 1/2, unless an exception applies. Exceptions to the early withdrawal penalty apply to the following types of distributions:

1. To a beneficiary because of the death of the Roth IRA owner;

2. Due to the disability of the owner of the Roth IRA (as defined by Sec. 72(m)(7));

3. That are a part of a series of substantially equal periodic payments made at least annually for the life (or life expectancy) of the Roth IRA owner or the joint life (or life expectancies) of the Roth IRA owner and the beneficiary;

4. To the extent that the distributions do not exceed the amount allowable as an itemized medical deduction (regardless of whether deductions are itemized);

5. To unemployed individuals for the purchase of health insurance premiums;

6. To pay higher education expenses; or

7. To pay for qualified first-time home buyer expenses.

The above exceptions do not apply to a conversion amount, to the extent the distribution would force an acceleration of income under the technical corrections provisions. These exceptions are the same penalty exceptions that apply to regular IRA accounts.

With the new rollover provisions, which allow single filers or joint return filers with adjusted gross income of $100,000 or less to convert existing traditional IRA accounts to a new Roth IRA account, new penalty provisions have been added. For taxable nonqualified distributions from a Roth IRA (which include rollovers from traditional IRAs that take place in 1999 or later), only the 10% penalty will apply. For taxable nonqualified distributions made from a Roth IRA account, which include rollovers made in 1998, the regular 10% penalty imposed on early distributions will apply, as well as all additional 10% penalty. This means, in effect, a 20% penalty on early withdrawals from a Roth IRA rollover that took place in 1998. This additional 10% penalty is assessed to penalize individuals for spreading the taxable income from the rollover over a four-year period. To make matters even worse, the IRS has stated that contribution withdrawals will be treated as distributed in the following order:

1. From conversion contributions from a regular IRA to a Roth in 1998;

2. From any other conversion contributions (1999 and later); and

3. From any contribution to a Roth IRA other than a rollover contribution.

Thus, early distributions made from an account that contains both rollover and regular contributions would be deemed made from rollover contributions first, and could result in the 20% penalty. Pending technical corrections would change the ordering rules to nonconversion contributions, conversion contributions, earliest first and then earnings.

The TRA '97 also added two new exceptions to the early withdrawal penalty for both traditional and Roth IRAs. The first is for the withdrawal of funds by "first-time home buyers." The 10% penalty does not apply to the first $10,000 of distributions made to an individual from an IRA for first-time home buyer expenses. A qualified first-time home buyer distribution is any payment or distribution received by an individual to the extent it is used to pay the "qualified acquisition costs" of acquiring the "principal residence" of a "first-time home buyer." A first-time home buyer can be an individual, a spouse, or any child, grandchild or ancestor of the individual or spouse. The term "qualified acquisition costs" means the costs of acquiring, constructing or reconstructing a residence; qualified acquisition costs include any usual or reasonable settlement, financing or other closing costs. "Principal residence" is defined under Sec. 121. Eligible first-time home buyer withdrawals cannot exceed $10,000 during an individual's lifetime. Neither the Code nor the legislative history indicates whether the $10,000 limit is per individual if two or more individuals together purchase a home for the first time; it seems that a husband and wife could each withdraw up to $10,000 from their respective IRAs. The amounts withdrawn must be used within 120 days of the date of withdrawal. If the 120-day rule cannot be satisfied, the amount can be recontributed without tax consequences.

The second new exemption from the early distribution penalty is for withdrawals to pay higher education expenses. Effective Jan. 1, 1998, the 10% penalty tax on early distributions does not apply to an IRA distribution if the taxpayer uses the money for "qualified higher education expenses." The expenses can be incurred by the taxpayer, the taxpayer's spouse or any child or grandchild of the taxpayer or spouse. Qualified higher education expenses include tuition at an eligible educational institution, as well as room and board as long as the student is enrolled at least half-time. Qualified higher education expenses also include fees, books, supplies and equipment required for enrollment or attendance. Expenses for graduate-level courses can be qualified higher education expenses. An eligible educational institution is any college, university, vocational school or other post-secondary educational institution described in Section 481 of the Higher Education Act of 1965. The amount of qualified education expenses for any tax year must be reduced as provided in Sec. 25A(g)(2) (which relates to certain tax-free scholarships, tax-free employer-provided educational assistance and tax-free distributions from an education IRA), in determining the amount that can be withdrawn from the Roth IRA penalty-free.

Many advertisements for Roth IRAs have indicated that they are not subject to "required minimum distributions." This statement is not totally accurate, Roth IRAs are not subject to required minimum distributions during the owner's lifetime, but may be subject to them after the owner's death. (A 50% penalty is assessed for failure to make the required distributions after the owner's death.) The provisions allow for an automatic spousal rollover if the spouse is the sole beneficiary, making the spouse the new owner and, therefore, avoiding the distribution requirements. A nonspouse beneficiary is required to start taking distributions over the beneficiary's life expectancy starting no later than December 31 of the year following the year of the owner's death, or take out the entire balance by December 31 of the year containing the fifth anniversary of the owner's death. A beneficiary would be well advised to take the distributions over his life expectancy, continuing to earn and compound tax-free while still in the Roth IRA. The "term certain" method is the only method available to a beneficiary who is not a spouse to determine the amount of the annual minimum distribution required.

The ability to earn money tax-free will make the Roth IRA an attractive retirement savings vehicle for many taxpayers. With proper planning, an individual can maximize tax-free earnings and minimize the tax effects. Without proper planning, the results could be costly.