Early withdrawals from Roth IRAs are deceptively complex.

• Author: Devine, Wendy S.

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...