Question 49)Franklin Thomas, age 51, is not married. He files head of household.

Question

Question 49)Franklin Thomas, age 51, is not married. He files head of household. His daughter, Finesse, age 19, attends State University and is in her second year. In 2014, Franklin withdrew $11,000 from his Roth IRA to pay for some of his daughter's qualified education expenses. Franklin established the Roth IRA in 2010 with $10,000. What is the tax consequence for taking this distribution?

A)$0 included in gross income; $0 penalty.

B)$1,000 included in gross income; $100 penalty excepted on Form 5329 with code 08.

C)$1,000 included in gross income; $100 penalty.

D)$11,000 included in gross income; $1,100 penalty.

Explanation / Answer

The tax treatment of a Roth IRA distribution depends on whether the distribution is qualified. Qualified distributions from Roth IRAs are tax and penalty free, but non-qualified distributions may be subject to tax and an early-distribution penalty (known as an excise tax). Generally speaking, the Roth IRA holder must be at least age 59.5 when the distribution occurs for it to be a qualified distribution. But there are exceptions.

The answer to your question depends on the source of the assets being withdrawn. If the source is only converted assets and it has been at least five years since the assets were converted, or if you qualify for one of the exceptions, then the 10% early-distribution penalty will not apply. If the assets being withdrawn come from earnings and none of the exceptions exists, the penalty will apply regardless of the time period elapsed.

In short, if it has been five years since the assets were converted and the amount withdrawn is less than or equal to the amount converted, no penalty will apply, despite the fact that you are under 59.5.

Let's use an example to illustrate. Assume that the amount converted more than five years ago was $10,000 and the assets have accrued earnings of $2,000. Under the ordering rules applicable to Roth IRAs, converted assets are always deemed to be withdrawn before earnings. Therefore, the $2,000 will not be withdrawn until after the $10,000 is withdrawn. If the individual withdraws $10,000 or less, the amount will be penalty free because it has been at least five years since the assets were converted.

If the individual withdraws $12,000, $10,000 of it will be penalty free, but $2,000 will be subject to the 10% penalty unless the individual meets one of the penalty exceptions. The $2,000 will also be subject to income tax if the distribution is not qualified.

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