What’s a non-qualified distribution from a Roth IRA?

A Roth IRA allows retirement savers to stash away part of their paycheck in a tax-advantaged retirement plan. The money grows tax-free over an investor’s working years, and any distributions in retirement will be tax-free. However, Roth IRA distributions may be classified into either qualified distributions or unqualified distributions depending on when you take the distribution.

A non-qualified distribution from a Roth IRA is a distribution that does not meet the IRS requirements for qualified distributions. Typically, non-qualified distributions occur when you take a Roth IRA distribution before age 59 ½ or when the Roth IRA account is not at least five years old. You will pay ordinary income taxes and penalties on non-qualified distributions. 

Roth IRA Withdrawal Rules

Since a Roth IRA is funded with post-tax contributions, you can withdraw the contributions you made to the account at any time and age without owing taxes. However, different rules apply if you withdraw the earnings generated from your distributions.

If you are below age 59 ½, you will pay taxes and penalties on the amount you withdraw. If you are 59 ½ or older, the distribution will be considered a qualified distribution, and you won’t owe any taxes.

If you rolled over a traditional IRA to a Roth IRA, you must pay taxes when you convert the retirement savings from pre-tax to post-tax. However, once you pay taxes on the conversion, you won’t pay further taxes if you make a qualified withdrawal. This means that any withdrawals made in retirement won’t have any tax consequences.

Qualified Distributions

A Roth IRA distribution must meet certain conditions to be considered a qualified distribution. Generally, the Roth IRA must be at least five years old since it was opened and you must be above age 59 ½. Also, the distribution may be considered a qualified distribution if you become completely disabled, you are using the money to build or buy a home as a first-time homebuyer, or when you take a series of equal periodic payments.

Non-Qualified Distributions

If a Roth IRA does not meet the conditions for a qualified distribution, it is considered a non-qualified Roth IRA distribution. A non-qualified distribution occurs when you take a distribution before age 59 ½, you have held the account for less than five years or if you don’t qualify for an exemption. You will pay ordinary income tax and an early distribution penalty on any non-qualified distributions you take.

However, there are situations when you may be exempted from paying the early withdrawal penalty on Roth IRA withdrawals. Some of these exemptions include unreimbursed medical expenses, a series of substantially equal payments, distributions to fulfill an IRS level, etc.  These exemptions allow retirement savers to use Roth IRA money to cover certain expenses that they are unable to cover using other savings.

Layers of Non-qualified Roth Withdrawals

When withdrawing money from your Roth IRA, you must use the first-in-first-out rule to determine where each withdrawal comes from. Generally, non-qualified distributions come from three different layers, and different rules apply to each layer.

The three layers include:

Regular contributions

The first layer comprises cumulative contributions for all your Roth IRA accounts. If you have several Roth IRAs in your name, you must treat them as a single account for purposes of withdrawals. You don’t pay taxes or penalties on the distributions, and you can withdraw part of or all the contributions at any time.

Conversion contributions

After you have exhausted your contributions, your next withdrawals will come from conversions from other retirement accounts. These conversions come from traditional IRAs that are rolled over to your Roth IRA. If you’ve paid taxes on the rollovers, you won’t pay taxes again, but you may owe a 10% penalty if you are under 59 ½ when you take the distribution. Conversion contributions may come from taxable and non-taxable conversion contributions.

Earnings on contributions

Once you have withdrawn all contributions and conversion contributions, you will remain with the cumulative Roth IRA earnings. Unless you meet the specifications for qualified distributions, withdrawing the earnings can trigger taxes and penalties. However, if you are age 59 ½ or older, and you have owned the Roth IRA for five years or more, you won’t pay any taxes or penalties when you withdraw the earnings.

When to take a Roth IRA Distribution

The best time to tap into your Roth IRA retirement money is when you retire. When you withdraw money in retirement, you won't owe any taxes or penalties on contributions, conversion contributions, and earnings from 401(k) investments. You can use the distributions to supplement other incomes in retirement like social security and 401(k) distributions.

However, if you have a financial emergency, and you have no other source of funds other than your retirement account, you may decide to take a Roth IRA distribution. However, you should determine if the amount you withdraw is subject to taxes, depending on whether you are withdrawing contributions and earnings.