Can the Roth IRA LLC participant take Roth IRA distributions prior to the 5 year period?
Yes. However, part or all of the distribution may be taxable depending on your age and the source of funds being distributed (basis vs gains). The IRS refers to the tax treatment of Roth IRA LLC distributions as either qualified (tax-free) or nonqualified (taxable). Under either scenario, the funds must first flow back to the Roth IRA from the LLC bank account before the distribution can be processed from the Roth IRA since the distribution is occurring from the Roth IRA not the Roth IRA funded LLC. If the funds are distributed from the LLC bank account to your personal bank account instead of from the Roth IRA, the Roth IRA prohibited transactions rules will be triggered.
The IRS Rules Required Roth IRA LLC Funds Distributed in the Following Order:
Regular Contributions: Roth IRA annual contributions for all years—contributions that were not tax-deductible when made—are deemed to be withdrawn first, and are tax- and penalty-free.
Conversions & Rollovers: After Roth IRA contributions have been distributed, next in line are amounts converted from Traditional IRAs and pretax amounts that have been rolled over from an employer-sponsored retirement plan such as a solo 401k plan (excluding rollover from Roth Solo 401k accounts) to a Roth IRA.
Earnings: Finally, after contributions and amounts converted have been distributed, Roth IRA earnings can be distributed.
The reason regular contributions, conversion and rollovers are not taxable is because they went into the Roth IRA on an after-tax basis (i.e., the Roth IRA owner did not deduct the these amounts on her taxes).
There are Two Five-Year Waiting Periods:
To further analyze if taxes will apply from the Roth IRA LLC distribution, the five year period has to be reviewed separately for the Roth IRA earnings and the Roth IRA conversions and pretax employer plan rollovers from 401k plans and other qualified plans.
The Five-Year Period for Earnings on Roth IRA Contributions:
Ad discussed above, Roth IRA contributions can always be distributed tax and penalty free; however, the earnings on Roth IRA contributions are subject to both the 5 year rule and the age 59 1/2 rule when determining if the distribution is “qualified” vs “nonqualified.”
The five-year period is per Roth IRA owner not per Roth IRA. Therefore, the Roth IRA owner may have multiple Roth IRAs, but the 5 year-period will apply to the first (oldest) Roth IRA not each Roth IRA. The five-year rule will also not start over even if all the Roth IRAs are emptied out and an new one is later opened.
For a Roth IRA distribution to be considered “qualified,” the following two requirements have to be satisfied:
1. Five Year Period: Starting on January 1 of the year the first Roth IRA contribution was made regardless if not made until the end of December, 5 years must have passed.
2. Age 59 1/2: The distribution must be made on or after the Roth IRA owner attains age 59½, has died, has become disabled, or has qualified first-time homebuyer expenses. See (IRC Sec. 408A(d)(2)(A)).
The Five-Year Period for Conversions and Rollovers from Qualified Plans (e.g., 401k plans):
Once all Roth IRA contributions have been distributed, the next to be distributed are traditional IRA conversions and rollovers from pretax qualified plans. Wiled the amounts converted will not be subject to taxes, the 10% early distribution penalty will apply if the account owner is under age 59 1/2 regardless if they have had the Roth IRA for less or over 5 years. The 10% penalty does not apply if the Roth IRA has been opened for both 5 years or longer and if the account holder 59 1/2 or older.
Note: If traditional IRA conversion or Rollovers from retirement plans were made to the Roth IRA in multiple years, the “first-in, firs-out” concept applies. This means the oldest traditional IRA funds and qualified plan rollovers will be first distributed.
Closing Comments
In sum, Roth IRA contributions are always tax free and penalty free. However, amounts converted to a Roth IRA from traditional IRAs or pretax qualified plans such as solo 401k plans will also not be taxable but may be subject to the 10% early distribution penalty if both the 5 year-rule and the age 59 1/2 rule are not met.
