Roth conversion issues are complex enough, but one element is especially perplexing: the five-year rule on withdrawals. Violate the rules and you could incur a 10% penalty as well as income tax on investment gains. If you’ll need to withdraw money that could trigger these costs, a Roth conversion might not be a good idea.
The five-year rule is especially hard to understand since there are actually two of them. One deals with contributions, the other with conversions. Let’s try to make sense of it all.
Opening a Roth
The first rule deals with a person who opens a Roth, rather than someone who converts a traditional IRA into a Roth. It says that contributions can be withdrawn at any time without penalty.
The five-year rule applies to withdrawals on earnings, or investment gains. The five-year period begins on Jan. 1 of the year the first Roth contribution was made. The earnings can be withdrawn without penalty or income tax after five years have passed and the investor has also reached 59 ½.
Both criteria have to be satisfied. If you open an account at age 58, for example, you would be subject to a 10% penalty and income tax on withdrawals of earnings in the next five years, even though you’d turn 59 ½ before that period ended. However, you could withdraw, with no penalty or tax, an amount equal to your contributions, even if the five years had not run out.
Finally, the clock starts ticking when the first contribution is made to the first Roth. That five-year period applies to all of the investor’s Roth accounts, even if some are not set up until later. In other words, if you opened one account at age 55 and another at 60, the five-year period would end for both accounts when you turn 60.
Converting to a Roth
Money converted to a Roth can be withdrawn penalty-free after five years, beginning Jan. 1 of the year of the conversion, or after the investor turns 59 ½, whichever comes first. A five-year clock starts with each conversion, not just the first one. (Because income tax was paid at the time of conversion, there is never a tax on withdrawals of converted sums, even if a 10% penalty applies.)
An investor who converts after turning 59 ½ can withdraw the converted sum at any time without waiting for five years to pass. Earnings, however, cannot be withdrawn without tax and penalty until the five years are over, even if the investor has passed 59 ½.
Order of withdrawals
The rules assume that any Roth withdrawals are made in a specific order. The first withdrawals are assumed to come from contributions. Once withdrawals exceed the original contributions, the next withdrawals are assumed to come from converted sums. And once that amount is surpassed, further withdrawals are assumed to come from investment gains.
As a result, the withdrawals most likely to trigger a penalty are automatically assumed to be made last, when the penalty is less likely to apply.
IRS Publication 590 details the withdrawal rules and notes some exceptions for things like hardship and buying a first home. It also has a worksheet for figuring whether penalties would apply.
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