There’s a lot of interest this year in converting traditional IRAs and 401(k)s to Roth IRAs. Some people hesitate to convert their IRAs, however, because of concerns about the confusing “five-year rule” for Roth IRAs.
Future distributions from a Roth IRA are tax free when they are “qualified distributions.” Meeting the five-year rule is one of the requirements for a distribution to be qualified.
The five-year rule is confusing partly because there really are two five-year rules. One five-year rule determines if a distribution from a Roth IRA avoids income taxes. The other five-year rule determines if a distribution taken before age 59½ avoids the 10% early distribution taxes.
Most of the time spent worrying about the five-year rule is wasted, because for most people it won’t be relevant. I’ll explain why after discussing the five-year rules.
The Five-Year Rule For Income Taxes
The first five-year rule determines whether a distribution of earnings passes one of the tests to be qualified and therefore free of income taxes. Since only after-tax money is contributed or rolled over to a Roth IRA, a withdrawal of the principal is free of income taxes.
Two tests must be met for a distribution to be qualified. One test is that five tax years must have passed since the first contribution was made to any Roth IRA for the taxpayer.
This is a broad rule, according to the Treasury regulations. The five-year period starts whenever money is put into any Roth IRA for the taxpayer. Under this rule, contributions include both direct contributions and converted amounts.
Some people believe this five-year rule applies separately to each Roth IRA. That’s not the case. Others think the five-year rule is applied separately to each Roth IRA conversion. That’s also not the case. There are worries that rolling over one Roth IRA to another, such as by changing IRA custodians, might restart the five-year period. Again, that’s not the rule.
The Roth IRAs of the taxpayer and the money flowing into Roth IRAs are aggregated to come up with one five-year period. Essentially, once you’ve satisfied this five-year rule for one Roth IRA, you’ve satisfied it for life for all Roth IRAs. That’s a reason that some advisors say if you might convert all or part of a traditional IRA to a Roth IRA in the future, you should convert or contribute a small amount to a Roth IRA now, so the five-year clock will start running.
The second test for qualified distributions is broader. The distribution must be made on or after at least one of the following events: the owner turned age 59½; the IRA owner passed away, so the distribution is made to the estate or a beneficiary; the distribution is made for first-time qualified home-buyer expenses of up to $10,000.
You must satisfy both tests for a Roth IRA distribution to be income tax free. For example, if you are at least age 59½ and have had a Roth IRA for at least five years, the distribution is qualified and tax free.
The Five-Year Rule for the 10% Penalty
The second five-year rule determines whether a distribution of principal from a converted IRA is subject to the 10% early distribution penalty. This rule applies only to the penalty.
This five-year rule states that the early distribution penalty isn’t imposed if at least five tax years have passed since the principal was converted.
This rule applies separately to each IRA conversion. If you’re doing conversions over a period of years, you have to track the amount of principal converted each year.
But another rule negates this five-year rule for most people who convert traditional IRAs to Roth IRAs. That’s because the 10% early distribution doesn’t apply once the owner is at least age 59½.
As an example, suppose Max Profits is 45 years old and converts a traditional IRA to a Roth IRA. At age 51, he needs the money from the Roth IRA and distributes the full account. The early distribution penalty doesn’t apply, because more than five years have passed since the conversion. But the distribution of the earnings of the Roth IRA are taxable, because Max was under age 59½ and didn’t meet any other tests to exempt the earnings from taxation. The distribution of the principal, or converted amount, isn’t taxable, because the taxes on that were paid when the conversion was done.
Each five-year rule isn’t really a full five-year rule.
That’s because the rules count tax years, or taxable years, not calendar years or 12-month periods. Under the tax code, a tax year starts on the first day of the year.
For example, you can make a contribution to a Roth IRA for tax year 2021 as late as April 15, 2022 (even later if the 15th falls on a weekend or holiday). Or you can convert an IRA as late as December 31, 2021. In either case, the five-year clock starts running on the first day of the tax year, January 1, 2021. So, the five-year period ends less than 60 months from the date of your action.
Even when you don’t meet the five-year rule and aren’t at least age 59½, you still can avoid the 10% early distribution penalty. There are exceptions to the 10% early distribution penalty that apply to both traditional IRAs and Roth IRAs. The exceptions include first-time home-buyer expenses, a series of substantially equal distributions, and payment of certain unreimbursed medical expenses, among others.
Why They Usually Aren’t Relevant
The second five-year rule for the early distribution penalty doesn’t apply to most people taking distributions during retirement, because it doesn’t apply to anyone older than age 59½.
The first five-year rule also won’t be relevant to many because of what are called the the ordering rules for Roth IRAs.
A Roth IRA will have two types of money in it. There will of course be the principal, which is the amount that was contributed or converted to the Roth IRA.
Then, there will be earnings on the principal, such as appreciation, capital gains, interest, dividends, and perhaps other earnings.
When you take a distribution from a Roth IRA that is less than the full IRA value, the ordering rules say principal is considered distributed first. Only after all principal is distributed are earnings considered to be distributed.
Distributions of principal from the Roth IRA aren’t taxable, because you already paid taxes on them. So, even if you’re within the five-year period, income taxes aren’t an issue until all the principal is distributed and earnings are being distributed.
The ordering rules also state that contributions are distributed first, then converted amounts and finally earnings are distributed.
A final point in the ordering rules is when there were conversions in different years, the conversions are considered to be distributed on a first-in, first-out basis. So, the first conversions are distributed first, and the most recent conversion is distributed last.
The five-year rules apply only to the original owner of a Roth IRA. They won’t apply to a beneficiary who inherits your Roth IRA.
These details are only for Roth IRAs. For Roth 401(k)s the rules are a little different. I won’t go into them now.
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September 29, 2021 at 06:30PM
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What You Need To Know About The Confusing Roth IRA Five-Year Rule - Forbes
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