How to get the most out of qualified distributions  

Qualified distributions are withdrawals from qualified retirement plans. Depending on the retirement plan, these distributions can be tax-free and penalty-free.  

But you need to know certain requirements before you can benefit. 

In this article, we will show you what qualifying distributions are and how they work. We will also outline the rules for qualified charitable distributions.  

Here is everything you need to know.  

What are qualifying distributions? 

Qualifying distributions allow you to avoid penalties and taxes earned on money withdrawn from a Roth retirement account. You contribute after-tax money to Roth accounts. However, the Internal Revenue Service (IRS) has specific requirements that you must meet, called qualifications. These qualifications help you to avoid paying taxes on withdrawals from these plans.  

Qualified distributions are Roth IRA or designated Roth account withdrawals. They are made under specific IRS requirements that incur no penalties or taxes. When taking out Roth earnings in retirement, qualifying withdrawals reduce your tax burden. 

If your distribution does not qualify under the IRS rules, withdrawing earnings from your Roth account could lead to implication of regular income taxes due on that portion. This may also lead to a 10% tax penalty if the withdrawal is made prior to your turning 59 ½ years of age. 

Let’s look at the basic IRS requirements for a qualified distribution when you make a withdrawal: 

• at age 59 ½ years old or older 
• due to your death, by or for your beneficiary 
• due to your disability 
• from a Roth account open for a minimum of five tax years, beginning the year you first contributed 
• up to $10,000 to purchase, build, or renovate your first home 

An example of qualified distributions 

You opened a Roth IRA with a brokerage 10 years ago and contributed the maximum allowable amount. Within that decade, you gained significant earnings from your contributions. You then decide, at 59 ½ years of age, to withdraw both your contributions and a portion of your earnings.  

Since you met the age and account requirements, your Roth IRA withdrawal is considered a qualified distribution. That means you will not face an early withdrawal penalty. It also means you can avoid income taxes on the withdrawn earnings portion.  

What are the rules for qualified charitable distributions? 

Qualified charitable distributions (QCD) can help you manage your requirement minimum distributions from the IRA.  

QCDs allow anyone 70 ½ years old or older to donate up to $100,000 total to one or more charities directly from a taxable IRA. You can do this rather than take their required minimum distributions. As a result, you can avoid being pushed into a higher income tax bracket. It also prevents phaseouts of other tax deductions. Keep in mind, however, that there may be other limitations. 

To better understand the rules for qualified charitable distributions, we need to start with understanding required minimum distributions (RMDs). If you have individual retirement accounts (IRAs), you are required to take RMDs every year starting at age 73. This is true whether you want or need the money. The same RMD increases your total taxable income. 

That increase in income could potentially push you into a higher income tax bracket. It can also trigger phaseouts. These eliminate or limit certain types of tax deductions, like itemized deductions and personal exemption. Occasionally, they can trigger high taxes on Social Security income. 

Are qualified distributions tax-free? 

Yes, qualified distributions are tax-free. However, there are certain requirements which must be met.  

Once Roth IRA funds have been held a minimum of five years, and the Roth owner is 59 ½ years old, there are no more tax rules. All distributions will be tax- and penalty-free forever. This includes distributions to beneficiaries. 

These distributions are also known as qualified distributions, and they are the Holy Grail for Roth IRAs. Confusion arises when converted funds are withdrawn before the five-year and 59 ½-year-old requirements are met.  

The key is to understand this and know that there are two different five-year clocks. In this section, let’s break down how these clocks play out. 

Tax-free qualified distributions of Roth earnings

The first deals with your tax-free earnings. This holding period starts when the first Roth IRA account is established. It also does not restart for each Roth IRA contribution or conversion.  

The holding period starts on January 1 of the tax year for which the first dollar of any Roth IRA money is contributed. This is the case even if that first contribution was made 10 years prior and the account was emptied and closed.  

An example of tax-free qualified distributions 

Sally established her first Roth IRA with a conversion in 2019, when she was 57. She must wait until the five-year holding period ends on Jan. 1, 2024, and until she is 59½, for the distribution of her earnings to be tax-free (a qualified distribution). Both qualifications must be met. 

At age 59½, Sally could withdraw the entire account penalty-free. However, any earnings would be taxable as she has not met the five-year holding period. 

Since she was 57 when she established her first Roth IRA, she must wait five years to earn the benefit of tax-free earnings. However, there would be no 10% penalty on the earnings because Sally was 59½ when the funds were withdrawn. 

Penalty-free qualified distributions from Roth conversions 

The other five-year clock only applies under the age of 59 ½. If the account owner is already 59½ or older, this rule can be ignored.  

When a traditional IRA is converted to a Roth, account owners who are under the age of 59½ must wait five years. At that point, they can take penalty-free distributions of funds that were taxable when converted (assuming no exception to the 10% penalty applies). 

We are not talking about earnings yet. We are talking only about avoiding the 10% penalty on distributions of converted dollars. This five-year clock will restart for each conversion that is done. 

While Roth distributions from converted funds are always tax-free (since the tax was paid when the funds were converted), they could still be subject to the 10% early withdrawal penalty. This is an anomaly in the Tax Code since normally the 10% penalty follows the taxable distribution. You generally can only have a 10% penalty on a taxable distribution. 

But when converted Roth funds are withdrawn before they are held for five years, they may be subject to the penalty, even though the actual distribution will be tax-free. Another oddity that creates confusion is that, unlike traditional IRA funds, converted Roth funds can be withdrawn penalty-free. This is true even if withdrawn before age 59½, if the five-year holding rule is met. 

An example of penalty-free qualified distributions 

David was 30 years old in 2015. He converted his traditional IRA to a Roth in September of that year and paid taxes on the full value of the conversion. 

The IRS recognizes the conversion as happening on the first day of the year. That means David’s holding period for the conversion began on Jan. 1, 2015. He must wait five years, until Jan. 1, 2020, before he can take penalty-free distributions of the converted assets. 

If David withdraws any of these converted funds before 2020, the distribution will be tax-free but subject to the 10% early distribution penalty. 

If, however, David withdraws the funds in 2020, he will have access to his converted assets tax- and penalty-free. That’s the case even though he will only be 35 in 2020. (Again, we are only talking about David’s converted assets here, not his earnings on those converted dollars.) 

What you need to know to benefit from qualified distributions 

Qualified distributions can be tax-free and penalty-free. However, you need to know the requirements to get the most bang for your buck.  

To find out more about qualified distributions, get in touch with one of the financial advisors that we highlight in our Awards & Recognition section. Here you will find the top-performing financial advisors across the USA.      

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