Qualified Distribution: Definition, How Plans Work, and Taxation

What Is a Qualified Distribution?

The term "qualified distribution" refers to a withdrawal from a qualified retirement plan. These distributions are penalty-free and can be tax-free, depending on the retirement account. Eligible plans from which a qualified distribution can be made include 401(k)s, 403(b)s, and individual retirement accounts (IRAs). Qualified distributions come with certain conditions and restrictions set by the Internal Revenue Service (IRS) so that the tax benefits and retirement-savings purpose of the plans aren't taken advantage of by investors.

How Qualified Distributions Work

The government wants to encourage people to save for their later years. It offers substantial tax benefits to those who save in qualified retirement accounts. As a result, many people pay into qualified plans in order to save for retirement. These plans include IRAs, 401(k)s, and 403(b)s.

To make sure people don't abuse these accounts and use them for reasons other than retirement or to avoid paying taxes, the IRS imposes taxes and penalties on withdrawals that don't meet the qualified distribution criteria. This means that if you withdraw money and the withdrawal does not meet the criteria for the account, you will be taxed and could pay an additional tax penalty.

However, if you meet the conditions, you can make a qualified distribution. For Roth accounts, you'll pay no taxes or penalties on qualified distributions. For tax-deferred accounts such as a traditional IRA or a 401(k), you'll pay no penalty but will owe taxes.

Tax-Deferred Accounts

Tax-deferred retirement plans require that the account holder be at least 59½ years of age to take a qualified distribution. Although the account owner will have to pay income tax on a tax-deferred plan qualified distribution, there will be no early withdrawal penalty. Tax-deferred plans include traditional IRAs, simplified employee pension IRAs, savings incentive match plans for employees IRAs, traditional 401(k)s, and traditional 403(b)s.

Roth IRAs

Unlike traditional IRAs, Roth IRAs do not provide a tax deduction for contributions. In other words, Roths are funded with after-tax dollars. However, Roth IRAs do provide tax-free withdrawals, as long as certain criteria are satisfied. The criteria for a qualified withdrawal are:

1. The owner of the account must have had the Roth IRA open for at least five tax years. Tax years count from January 1 of the first tax year when a contribution was made.
2. The owner must be 59½ years old or permanently disabled, taking withdrawals from an inherited account, or taking out up to $10,000 as a first-time homebuyer.

If the distribution is qualified, you'll pay no taxes on a Roth IRA withdrawal. However, if you fail to meet these requirements, the withdrawal will not be considered a qualified distribution and you'll owe taxes and penalties on earnings.

Designated Roth Accounts

Designated Roth accounts are employer-sponsored plans, such as a Roth 401(k) or Roth 403(b), with an after-tax savings option. These plans also have two requirements for qualified, tax-free distributions. The first is the same as the Roth IRA—the account must have been opened for at least five tax years. The second requires the account holder to be at least 59½ years of age, permanently disabled, or taking withdrawals from an inherited account. Whether or not you are buying a first home won't help you in this case.

Special Considerations

If you make an early withdrawal, a 10% early withdrawal penalty will apply to the taxable portion of your non-qualified distributions, unless an exception applies. For tax-deferred accounts, that means the entire distribution will be taxed unless you've made nondeductible contributions.

For designated Roth accounts, early withdrawals are apportioned between your contributions, which are tax free and, therefore, penalty free and your earnings, which are taxed and penalized. For Roth IRAs, early withdrawals apply to all your after-tax contributions before earnings are even considered. Those are tax- and penalty-free withdrawals. Subsequent early withdrawals are then taxed and penalized.

If you are taking an early, taxable withdrawal, you can avoid all or a portion of the penalty (but not the income taxes) if you qualify for an exception. You can qualify if you:

• Are permanently disabled
• Withdraw funds as a beneficiary
• Take a qualified reservist distribution—a distribution made from a retirement account to a military reservist or member of the National Guard called to active duty

If you're taking an early withdrawal from an employer plan, you avoid the penalty if you're at least 55 years old when you leave your job. Penalty exceptions for IRA account holders include first-time homebuyer expenses up to $10,000, medical insurance premiums when unemployed, and use of funds for qualified higher education expenses.

Additional rules pertaining to certain qualified retirement accounts include required minimum distributions (RMDs) after the account holder turns 73 (as of 2023). For 401(k) accounts, there is an exception to this. If you still work for the company that sponsors your 401(k) when you turn 73 and you don't own more than 5% of the company, it's possible to avoid RMDs while you continue to be employed. Not all plans offer this so be sure to check with yours.

Qualified Distributions as Direct and Indirect Rollovers

Direct and indirect rollovers are key aspects of qualified distributions. Most rollovers—whether direct or indirect—occur when people change jobs. But some occur when account holders want to switch to an IRA with better benefits or investment choices.

In a direct rollover, the retirement plan administrator transfers the plan’s proceeds directly to another plan or an IRA. In an indirect rollover, a plan administrator issues an employee a check that is to be deposited by the employee into another plan, e.g., an IRA. With an indirect rollover, it is up to the employee to redeposit the funds into the new IRA within the allotted 60-day period to avoid penalty.

The Bottom Line

Qualified distributions are withdrawals from qualified retirement accounts such as 401(k)s, 403(b)s, and IRAs. To be considered qualified, distributions must meet certain IRS rules. If withdrawals fail to meet these rules, the amounts can be taxed at regular income tax rates and may face an additional 10% tax penalty for early withdrawal.

The IRS levies taxes and penalties on unqualified distributions to discourage individuals from abusing the long-term savings purpose and tax advantages of qualified retirement accounts.