Life and Death Planning for Retirement Benefits

Chapter 5: Roth Retirement Plans

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You Can Never Stop Tracking “Basis” Vs. “Earnings!”

The Ordering Rules Any distribution from a Roth IRA is deemed to come from the following sources, in the order indicated. § 408A(d)(4)(B) ; Reg. § 1.408A-6 , A-9. These rules are referred to in this book as the Ordering Rules. These rules apply to all Roth IRA distributions except corrective distributions ( ¶ 2.1.08 ) (Reg. § 1.408A-6 , A-9(e)) and recharacterizations (¶ 5.6) . 1. Any distribution is deemed to come, first, from the participant’s contributions to his Roth IRA(s), to the extent that all previous distributions from his Roth IRA(s) have not yet exceeded the contributions; and 2. If the participant has made both “regular” ( ¶ 5.3.02 ) and “rollover” (conversion) (¶ 5.4) contributions, the distributions are deemed to come, first, from the regular contributions, then from rollover contributions on a first-in, first-out, basis; and 3. Once it is determined that the distribution is deemed to come from a particular rollover contribution (conversion), the dollars that were includible in gross income by virtue of that conversion ( ¶ 5.4.03 ) are deemed distributed first. (All of the rollover would have been included in income except the participant’s own after-tax money that was part of the conversion; see ¶ 2.2.) This particular ordering rule matters only to someone who is under age 59½ at the time of the Roth IRA distribution (see ¶ 5.5.02 ); and It might appear that once the client has met the requirements for a qualified distribution ( e.g. , he is over age 59½ and has completed the Five-Year Period), he could breathe a sigh of relief and stop keeping track of how many dollars in the Roth account constituted “basis” versus “earnings.” Not so! There is always the possibility that a nonqualified distribution may occur even after that point—for example, if there is a prohibited transaction ( ¶ 5.2.04 ). The example in the regulations is a disabled individual who receives a qualified distribution from a DRAC, then later ceases to be disabled and takes another distribution from the DRAC before reaching age 59½. Reg. § 1.402A-1 , A-7. See the last sentence of ¶ 5.7.06 for how to eliminate the need for such tracking with respect to a DRAC.

4. Finally, once all contributions have been distributed, the balance of the distribution comes out of earnings. Whew!

Fortunately, practitioners will rarely if ever need to consult the Ordering Rules:

 For most people, the Ordering Rules matter only for purposes of determining whether a nonqualified distribution is subject to income tax; the Ordering Rules essentially mean that the participant’s already-taxed contributions to the Roth IRA come out first and accordingly distributions from the Roth IRA are NOT taxable until the total di stributed exceeds those contributions.