IRA Distribution Confusion
Traditional and Roth IRA owners often get confused about the distributions they take from their IRAs. Mix-ups and misunderstandings are pervasive. With Roth IRAs, there a number of different factors to consider when withdrawing funds. How long has the account been open? How old is the Roth IRA owner? What type of dollars are in the Roth IRA (i.e., contributions, conversions, earnings)? With traditional IRA withdrawals, we must consider the pro-rata rule when after-tax (non-deductible) dollars are present, which dictates how much of the distribution is taxable. Like the flu in winter, on and on the confusion spreads. Here are a some common “distribution confusions” for Roth and traditional IRA owners:
Rental Property in a Roth IRA
It is perfectly acceptable to own real estate in a Roth IRA. Commercial property, a beach house, an apartment building — all are allowed. Of course, the prohibited transaction rules dictate that the IRA owner must keep an arm’s-length distance from these properties. Assuming the underlying property management is set up perfectly within the Roth IRA, how do we treat the rental income that kicks out from these properties?
Anyone who takes these “rental income” payments from their Roth IRA must forget where the dollars originated. For tax purposes, this is not rental income, just like dividends received from a stock held in a Roth IRA are not “dividends.” Any payment from a Roth IRA is some combination of contributory dollars, converted dollars or earnings. And since Roth IRAs follow strict distribution ordering rules, what might be thought of as a “rental income payment” is most likely a return of contributions or converted dollars. There is no special “rental income” tax treatment when these funds are distributed from a Roth IRA.
Multiple Roth IRAs Are Considered One Roth IRA
Continuing with the aforementioned rental property situation, if a person holds their property in one Roth IRA and has all their “standard” investments (like stocks and mutual funds) in a different Roth IRA, the IRS does not care. All it sees is a single Roth IRA account. Within this single account are up to three buckets of money: contributions, converted dollars and earnings, and that is what gets paid out. Any distribution (like “rents”) from any of a person’s Roth IRAs follow that same distribution order. Layer on the 5-year holding period and a person’s age (under or over 59½) and it’s easy to see how “distribution confusion” can make a Roth IRA owner nauseous.
10% Penalty Exception Does NOT Mean Tax-Free
There are currently 20 exceptions to the 10% early withdrawal penalty for IRAs and work plans, with a 21st coming in 2026. While the penalty could be avoided by leveraging an exception, the taxes cannot! If you qualify for one of the exceptions and need to withdraw traditional pre-tax IRA funds, be aware that a tax bill will be due.
The Pro-Rata Rule
Speaking of taxes due on traditional IRA distributions, it is important to know that the pro-rata rule simultaneously looks at all of a person’s traditional IRAs, SEP and SIMPLE IRAs. If you have after-tax (non-deductible) dollars in any of these accounts, you cannot cherry-pick only those dollars for withdrawal or conversion. What the pro-rata rule does NOT look at are your inherited IRAs, your spouse’s IRA, or work plans like a 401(k).
“IRA Distribution confusion” is a real malady, and it’s as common as a cold.
By Andy Ives, CFP®, AIF®
IRA Analyst
Ed Slott and Company, LLC
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Christian Cordoba, founder of California Retirement Advisors, has been a member of Ed Slott's Master Elite IRA Advisor Group since 2007.