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1. The Two 5-Year Rules Compared: As a starting point, it’s helpful to understand how the 5-year rule applies to Roth IRA contributions versus conversions.
Roth IRA Conversions: The 5 year rule on conversions is used to determine whether you’ll pay the 10 percent penalty when you withdrawal the amount you converted.
Roth IRA Contributions: The 5 year rule as applied to contributions is used to determine whether you’ll owe ordinary income tax on the earnings from those contributions. Remember, the actual contributions can be withdrawn at any time tax and penalty free.
2. The Purpose of the 5-Year Rule: Understanding the purpose of the 5-year rule as applied to Roth IRA conversions can go a long way to understanding the rule. Imagine you had a traditional IRA and you wanted to withdrawal the money before turning 59 1/2. While you understand you’ll have to pay ordinary income tax on the distribution, you’d really like to avoid the 10% additional tax (sometimes referred to as a penalty). So you get the idea that you’ll first convert the traditional IRA to a Roth IRA. You’ll pay the tax on the conversion. And then once converted, withdrawal the money from the Roth IRA as a way to avoid the 10% penalty. The IRS is ahead of you on this one. That’s why they have the 5-year waiting period. It prevents individuals from side-stepping the 10% penalty simply be converting a traditional IRA to a Roth IRA. Keep that in mind as you read the rest of this article.
3. When Does the 5-Year Rule Start to Run: Now let’s get to the nuts and bolts of the rule. The 5-year clock starts to tick as of January 1 of the year in which you make the conversion. For example, a Roth IRA conversion in September of 2014 would start the 5 year conversion clock as of January 1, 2014.
4. The Rule Applies to Each Conversion: The 5 year rule applies separately to each and every conversion. Keep in mind that this is different than the 5-year rule as applied to contributions. You have to meet the 5 year rule separately for each and every conversion to avoid the 10% penalty (unless an exception applies as noted below).
5. Distribution Ordering Rules: For most, a Roth IRA consists not only of amounts converted from a traditional IRA, but also contributions and earnings from both contributions and conversions. This raises the question of how the IRS characterizes a withdrawal. Here’s what you need to know.
Ordering: Distributions are deemed to come first from contributions, then conversions, and finally earnings. Conversions are further broken down first from taxable conversions (conversions that triggered taxes) and then non-taxable conversions. We’ll look at some of the implications of this ordering rule in a minute.
Combined Accounts: The IRS treats multiple Roth IRA accounts as one for tax purposes. Even if you have multiple Roth IRA accounts, they will be treated as one regardless of which one you actually take a distribution from.
You can use the ordering rules to your advantage. For example, if your withdrawal does not exceed the amount of your total contributions, you won’t owe ordinary tax or the 10% penalty because the IRS deems the distribution to come first from contributions.
FIFO: The IRS uses a First-In-First-Out rule on distributions. For example, if a taxpayer has made multiple taxable conversions over a number of years, distributions of these conversions are deemed to come first from the oldest conversion.
6. Applying the Rule to Those Younger than 59 1/2 Who Have NOT Met the 5-Year Rule: For those under 59 1/2 (and assuming no other exceptions such as total disability apply), there are two possilities–You’ve either met the 5-year rule for a particular conversion or you haven’t. Here’s how the rule applies if you have NOT met the 5-year rule:
Conversion (Taxable): Tax-No; Penalty-Yes
Conversion (Non-Taxable): Tax-No; Penalty-No
Explanation: Conversions that were taxable (e.g., conversions from a traditional IRA that held pre-tax contributions) will be subject to the 10% penalty if the 5-year rule is not met. This is to prevent people from using the Roth IRA conversion as a way to side-step the 10% penalty.
Conversions that were not taxable (e.g., conversions from a traditional IRA that held after-tax dollars) are not subject to the penalty because you could have withdrawn them from the traditional IRA without penalty anyway.
Remember that a conversion from a traditional IRA to a Roth IRA can include both taxable and non-taxable dollars.
7. Applying the Rule to Those Younger than 59 1/2 Who HAVE Met the 5-Year Rule:
Conversion (Taxable): Tax-No; Penalty-No
Conversion (Non-Taxable): Tax-No; Penalty-No
Since the taxes have already been paid (at conversion or earlier) and the 5-year rule has been met, there is no penalty or tax.
8. Applying the Rule to Those 59 1/2 or Older:
Once age 59 1/2 has been reached, there will be no 10% penalty even if the 5-year rule on conversions is not met. Why? Because there would be no penalty on a distribution from a traditional IRA at age 59 1/2 or older.
9. Early Retiree Strategies: There are some strategies here for early retirees. While the 5-year rule prevents penalty avoidance with a conversion and immediate distribution, it does allow for penalty-free distributions after five years. In exchange, you have to pay the tax on the conversion at least five years before you withdrawal the money. But the result can be access to retirement funds long before 59 1/2 without paying the 10% additional tax.
What some do is to create a Roth IRA conversion ladder. They will convert to a Roth IRA one year of living expenses each year for a number of years. By converting a little bit each year rather than all at one time, it reduces the tax liability on the conversion and potentially keeps the taxpayer out of a higher tax bracket. At the same time, for each conversion, it starts the 5 year clock running. At the end of five years, they will be able to begin withdrawing a year’s worth of expenses without paying the 10% penalty.
Finally, keep in mind that these rules can be very difficult to follow and apply. Before making any decisions, consult with a tax professional.