I continue to receive a lot of questions about the five-year waiting period for taking distributions after Roth IRA contributions and conversions. There’s a lot of confusion about the rules. It is slightly different for conversions and for contributions. It also is different for income taxation of distributions and the 10% early distribution penalty on distributions. Here’s how I described the rules in the May 2010 issue of Retirement Watch.
The five-year waiting period also generates many questions.
Only qualified distributions from a Roth IRA are tax-free. For a distribution to be qualified, the Roth IRA must be open at least five years. For regular Roth IRA contributions, the five-year rule is met if any Roth IRA owned by the taxpayer is at least five years old. If you opened a Roth IRA in 2000, for example, any distributions you take out of any regular Roth IRA now are tax-free.
The rule is different for converted Roth IRA amounts. A new five-year waiting period starts for each conversion. That means income and gains from the converted amount are taxable if withdrawn within five years of the conversion.
For most people, however, the five-year waiting period doesn’t matter. The rules for taxing Roth IRA distributions are that distributions are first considered to be of after-tax contributions. Distributions of after-tax contributions (such as converted amounts on which you paid the conversion tax) are tax-free. Only after all after-tax contributions (whether regular contributions or converted amounts) are withdraw are you withdrawing potentially taxable income and gains. So, the five-year rule doesn’t matter, unless you withdraw all or most of the IRA within five years. Even then, you’ll pay taxes only on the accumulated income and gains distributed not on the after-tax contributions.
The five-year period for either type of contribution begins on Jan. 1 of the year of the contribution or conversion, not on the date of the contribution or conversion.