This month we’re going to look at what lately has been the question I’m asked the most distribution from a Roth IRA isn’t tax free until at least five years have passed.
Longtime readers know I believe rules of thumb and shortcuts are dangerous, and this is a good example. The summary stimulates a lot of questions. Do I have to wait five years each time I make a contribution to a Roth IRA or do a conversion? Does the five-year period restart if I rollover the Roth IRA to a new custodian or another Roth IRA? If I pass away does the five-year period restart for my beneficiary? Those are just a few questions that arise.
One reason there’s a lot of confusion is most people don’t realize there are two separate five-year Roth IRA rules that have to be considered separately.
The Five-Year Rule for Contributions
The first five-year rule applies to contributions to roth iras and controls whether distributions of earnings will be tax free.
Only “qualified distributions” from a Roth IRA are tax free. 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 by the taxpayer.
This is a broad rule, according to the Treasury regulations. The five-year period starts whenever the IRA owner puts money into any Roth IRA. Under this rule, contributions include both direct contributions and converted amounts.
Some people have thought this five-year rule applies separately to each Roth IRA. That’s not the case. Others have thought the five-year rule is applied separately to each Roth IRA conversion. That’s also not the case. There have been worries that rolling over the Roth IRA to another 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 fiveyear period. Essentially, once you’ve satisfied the five-year rule, you’ve satisfied it for life. That’s a reason that some advisors say if you’re interested in 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 tax free. For example, you must be at least age 59½ and must have had a Roth IRA for at least five years for the distribution to be tax free.
The Five-Year Rule for Conversions
The second five-year rule determines whether a distribution of principal from a converted IRA is subject to the 10% early distribution penalty.
The rule applies only to the penalty. The other rule determines whether the distribution is taxable.
This second rule states that the early distribution penalty isn’t imposed if at least five tax years have passed since the principal was converted to a Roth IRA.
There are a couple of important points with this rule. One point is that it applies separately to each IRA conversion. That means if you’re doing conversions over a period of years, you have to track the amount of principal converted each year.
The second point negates the importance of this rule for most of my readers and most people who convert traditional IRAs to Roth IRAs. This point is that there are other ways to avoid the 10% penalty and the most commonly used one is for the IRA owner to be at least age 59½. Once you’ve hit that age, a distribution no longer is considered early, so the early distribution penalty doesn’t apply.
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 is taxable, because Max hasn’t met any of the requirements for a qualified distribution under the first five-year rule. The distribution of the principal, or converted amount, isn’t taxable, because the taxes on that were paid when the conversion was done.
Some Other Important Points
The five-year rules aren’t nearly as onerous or even as important as many people suppose for a couple of reasons.
The first reason is that each rule talks about tax years, not calendar years.
A tax year starts on the first day of the year, so you really don’t have to wait five full calendar years before qualifying under either five-year rule
For example, you can make a contribution to a Roth IRA for tax year 2018 as late as April 15, 2019 (even later if the 15th falls on a weekend or holiday). Or you can convert an IRA as late as December 31, 2018. In either case, the five-year clock starts running on the first day of the tax year, January 1, 2018. So, the five-year period is less than 60 months from the date of your action.
A second point is that many people overlook what are known as the ordering rules for Roth IRAs. When you take a distribution from a Roth IRA that is less than the full IRA value, the ordering rules determine whether the distribution is of principal or earnings.
The ordering rules state that distributions are first considered to be of principal. Only after all principal is distributed are earnings 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.
A third point is that the details of the five-year rules are a bit different for Roth 401(k)s. I won’t go into those details now.
While the five-year rules are complicated and confusing, they don’t matter to most people taking money out of Roth IRAs during retirement. You’ll be older than age 59½, so the early distribution penalty won’t apply.
You’re also likely to be withdrawing money gradually over time. That means you will withdraw principal first, and that’s not taxable. Only after all your principal has been withdrawn do you have to worry about some of the distribution being taxable. Most likely, five years will have passed by then, so the distributions will be tax free.