2010 is the year the income limitations were removed from Roth Conversions.

In a previous article, Tax Talk: 2010 Roth IRA Conversions published on Dec. 2, 2010, I discussed these new changes. This is a follow-up column. (If you are interested in the first article, go to www.syvjournal.com, archive and search for Roth IRA.)

Since everyone is abuzz with Roth Conversions and finding ways to contribute to their Roth IRAs, it seems like a good idea to discuss the obvious next question: What happens when I take the money out? This seemingly simple question leads to a maze of regulations. This article explores that maze.

The first question that must be determined is whether the distribution from the Roth IRA is a qualified distribution. If it is not a qualified distribution, it is a nonqualified distribution by default. Qualified distributions are not subject to federal income tax, and not subject to the additional 10% withdrawal penalty on early distributions. A qualified distribution from a Roth IRA is made after a one-time “five year” period and (two-prong test) the taxpayer meets one of the following requirements:

• Age 59½ or older at time of distribution

• Made on account of disability

• Made to pay for qualified first-time home purchase

• Made to a beneficiary or estate on account of the IRA owner’s death

The five-year period begins on Jan. 1 of the tax year of the first contribution to the Roth IRA. This is so even if the Roth IRA is made in the following year prior to the deadline for filing the return. For example, if a taxpayer makes an initial Roth contribution on April 13, 2011, for the 2010 tax year, the five-year period begins Jan. 1, 2010.

All distributions that do not satisfy the requirements to be qualified distributions are considered nonqualified distributions.

The ordering rules for nonqualified distributions are used to determine the tax and penalty consequences. The ordering rules for nonqualified distributions are summarized as follows:

(1) All distributions up to the total annual Roth contributions are tax- and penalty-free.

(2) Taxable amounts of conversions (i.e. amount taxable on date of conversion) are tax-free, but may be subject to the withdrawal penalty if none of the withdrawal penalty exceptions apply.

(3) Nontaxable amounts of conversions (i.e., return of nondeductible IRA contributions) are tax-free and penalty free.

(4) Roth IRA earnings are taxable and may be subject to the withdrawal penalty if none of the withdrawal penalty exceptions apply.

Withdrawal penalty exceptions include the following:

• Taxpayer is age 59 1/2 or older

• IRS levy

• Made as part of a series of substantially equal periodic payments over the taxpayer’s life or life expectancy

• Made to a beneficiary or estate on account of the IRA owner’s death

• Made to pay for a qualified first-time home purchase

• Not in excess of the taxpayer’s qualified higher education expenses

• Not in excess of certain medical insurance premiums paid while unemployed

• Not in excess of unreimbursed medical expenses that are more than a certain percentage of the taxpayer’s adjusted gross income

• Made on account of disability

• Is a qualified reservist distribution

To avoid abuses related to early withdrawals after a conversion, a required five-year holding period applies for each Roth conversion. The five-year holding period for each Roth conversion begins on Jan. 1 of the year in which the conversion took place. Unless one of the early withdrawal penalty exceptions applies, the portion of a nonqualified distribution related to the taxable amount of a Roth conversion would normally be subject to the early withdrawal penalty.

However, after the conversion five-year holding period is satisfied, any taxable amount from the conversion is not subject to the early withdrawal penalty, even when none of the withdrawal exceptions apply. Each conversion has a separate required five-year holding period.

Note the five-year holding period for conversions only applies for purposes of the early withdrawal penalty and is different than the one-time, five-year period on Roth contributions (discussed above).

Roth IRAs have complex distribution rules. Often the qualified distributions requirements and withdrawal penalty exceptions have specific definitions that must be followed. Also certain situations, such as a taxpayer having completed one or more Roth conversions, warrants further analysis to minimize the tax and penalty implications of withdrawal.

In addition, when one spouse is 59½ or older and the other is younger, the decision regarding whose Roth IRA will be used for withdrawal may have a significant impact. You contributed or converted to a Roth IRA with the idea it would not be taxed at the other end. To protect your retirement, always consult with your tax professional before making any retirement distributions. They can help you avoid or minimize the tax and penalty pitfalls. It is your money. You worked hard for it. Just a little advanced tax planning can make sure it ends up in your pocket and not the government’s coffers.

Carolyn M. Bayliss, CPA, Principal in Santa Maria CPA Firm of Lapp, Fatch, Myers & Gallagher