Income and Assets · Retirement income

Traditional and Roth IRAs compared, and their distributions

The two accounts differ on three axes: when tax is paid, who may contribute, and how a distribution is taxed. Only the third produces real difficulty, and within it one rule accounts for most errors — the five-taxable-year period, which is a second and independent condition on a qualified distribution rather than an alternative to reaching age 59½.

The rule

Deduction now or exclusion later. A contribution to a traditional IRA may be deductible under § 219, subject to the § 219(g) active-participant phase-out, and distributions are then taxed under § 72 (IRC § 408(d)(1)). No deduction is allowed under § 219 for a contribution to a Roth IRA (IRC § 408A(c)(1)), and a qualified distribution from a Roth IRA is not includible in gross income (IRC § 408A(d)(1)).

Who may contribute differs. The Roth contribution limit is the § 219 maximum computed without regard to § 219(g), less contributions to all other individual retirement plans (IRC § 408A(c)(2)) — but it is then reduced by reference to adjusted gross income above an applicable dollar amount (IRC § 408A(c)(3)(A), (B)). So a traditional contribution is always permitted and the deduction phases out; a Roth contribution itself phases out.

A qualified distribution needs two things, not one. It must be made on or after the individual attains age 59½, on or after death, on account of disability within § 72(m)(7), or as a qualified special purpose distribution (IRC § 408A(d)(2)(A)(i)–(iv)) — and it must not fall within the 5-taxable-year period beginning with the first taxable year for which the individual made a contribution to a Roth IRA (IRC § 408A(d)(2)(B)). Both limbs are required. A distribution at seventy within four years of the first contribution is not qualified.

The clock is personal, not per account. The period begins with the first taxable year for which the individual — or their spouse, or an employer in the case of a SIMPLE or simplified employee pension — made a contribution to a Roth IRA established for that individual (IRC § 408A(d)(2)(B)). Opening a second Roth twenty years later does not restart it.

The qualified special purpose distribution is the first-time homebuyer one. It means any distribution to which § 72(t)(2)(F) applies (IRC § 408A(d)(2)(C)) — a distribution used within 120 days for qualified acquisition costs of a principal residence of the individual, a spouse, or a child, grandchild or ancestor of either (IRC § 72(t)(8)(A)), subject to a lifetime dollar limitation (IRC § 72(t)(8)(B)).

A non-qualified Roth distribution is not automatically taxable. Ordering rules treat it as made first from contributions to the extent of aggregate contributions — regular contributions before qualified rollover contributions, and those first-in first-out (IRC § 408A(d)(4)(B)(i), (ii)). Because contributions were never deducted, that part comes out tax-free; only earnings, reached last, are includible.

Lifetime required distributions apply to one and not the other. Notwithstanding § 408(a)(6) and (b)(3), § 401(a)(9)(A) and the incidental death benefit requirements do not apply to a Roth IRA (IRC § 408A(c)(4)(A), (B)) — before death only. A traditional IRA is subject to them.

The early distribution tax sits underneath both. An amount received from a qualified retirement plan increases the tax by a percentage of the portion includible in gross income (IRC § 72(t)(1)), subject to the § 72(t)(2) exceptions. Because a Roth’s returned contributions are not includible, they attract no additional tax even when the distribution is not qualified.

Current figures

How it works in practice

Establish the five-year clock at intake and record it, because it is a fact about the client rather than about any account and no custodian statement will show it reliably. The earliest Roth contribution year is the whole of it. For a client who has held a Roth for decades the point is trivial; for one who opened a first Roth recently it decides the answer, and it decides it independently of their age.

Then read a non-qualified distribution through the ordering rules rather than treating it as taxable. A client who withdraws less than their cumulative contributions before the clock has run has withdrawn contributions, and contributions were taxed on the way in — so nothing is includible, and the § 72(t) additional tax, which applies only to the includible portion, does not bite either. Only when withdrawals exceed cumulative contributions do earnings come out.

For the contribution decision, keep the two phase-outs apart. A high-income client who is not an active participant may deduct a full traditional contribution while being barred from any Roth contribution — the tests are different in kind, not just in amount. And a client above the Roth range can still make a non-deductible traditional contribution, which is permitted at any income.

Finally, treat the lifetime distribution difference as a planning fact rather than a compliance one. A traditional IRA forces withdrawals in the owner’s lifetime; a Roth does not, which changes what the account is for.

How this has changed

The architecture of § 408A has been stable, and what moves each year is the two sets of income figures — the § 408A(c)(3) Roth contribution phase-out and the § 219(g) traditional deduction phase-out — both announced annually. They are different numbers doing different jobs, and material that presents “the IRA income limit” as a single figure is conflating them.

Two amounts in this topic do not move, which is worth knowing because they are the ones most often recited from memory. The § 72(t)(8)(B) first-time homebuyer lifetime limit is statutory and has never been adjusted, so its real value has eroded to the point where it rarely covers a deposit. And the threshold for a married individual filing separately is expressly not subject to cost-of-living adjustment, so it stays where it is while every neighbouring figure rises.

The larger change is what the Roth is now used for. The § 408A(c)(4) exemption from lifetime required distributions, combined with the annually rising traditional deduction phase-out, has moved the Roth from a savings vehicle toward an estate-planning one for many taxpayers — which makes the conversion rules, rather than the contribution rules, the ones most often engaged. Nothing in the section changed to bring that about.

Exam focus

The reliable question is the two-part qualified distribution test. Expect facts satisfying the age limb and failing the time limb, or the reverse, and know that both are required.

Know that the five-year period runs from the first taxable year for which any Roth contribution was made by the individual, their spouse, or an employer — not from the opening of the account in question.

Know the ordering rules well enough to say that a non-qualified distribution is frequently untaxed, and that IRC § 72(t) reaches only the includible portion.

Distinguish the two phase-outs. Roth: the contribution is limited. Traditional: the deduction is limited, and only for an active participant or their spouse.

Check yourself

1. A 65-year-old made their first Roth contribution three years ago and now withdraws earnings. Is the distribution qualified?

Answer: no. IRC § 408A(d)(2)(B) provides that a distribution within the 5-taxable-year period beginning with the first taxable year for which the individual made a contribution to a Roth IRA is not a qualified distribution, whatever § 408A(d)(2)(A) limb is satisfied. The earnings are includible. The IRC § 72(t) additional tax does not apply, because the taxpayer is over 59½.

2. A 40-year-old has contributed $52,000 to a Roth over many years and withdraws $30,000. What is the tax?

Answer: none. The distribution is not qualified, but IRC § 408A(d)(4)(B)(i) treats it as made from contributions to the extent that the distribution, added to all previous distributions, does not exceed aggregate contributions — and $30,000 is well within $52,000. Contributions were never deducted, so nothing is includible, and IRC § 72(t)(1) applies only to the portion includible in gross income.

3. A married couple filing jointly with adjusted gross income of $280,000, neither covered by a workplace plan, ask whether they can use IRAs.

Answer: they may each make a fully deductible traditional contribution, and neither may contribute to a Roth. The IRC § 219(g) phase-out applies only where the individual or their spouse is an active participant, which neither is, so income is irrelevant to the deduction. IRC § 408A(c)(3) reduces the Roth contribution limit by reference to adjusted gross income, and $280,000 exceeds the top of the joint range.

4. Does a Roth IRA owner have to take required minimum distributions during their lifetime?

Answer: no. IRC § 408A(c)(4) provides that, notwithstanding § 408(a)(6) and (b)(3), § 401(a)(9)(A) and the incidental death benefit requirements of § 401(a) do not apply to a Roth IRA. The heading confines this to the period before death, so distributions to beneficiaries after the owner’s death are governed by the ordinary rules.