ROTH IRAS AND THE 5-YEAR RULES

We constantly see questions regarding the distribution rules for Roth IRAs. Personally, I’ve always thought that the failure to understand these rules prevents many from truly appreciating the benefits of these accounts. Traditional IRAs are easy. Unless we are talking about nondeductible contributions, the money is deductible when contributed and taxable upon withdrawal. There’s also the early distribution penalty that could apply depending on the circumstances.

Roth IRAs have a couple of different rules, including two separate 5-year rules. The easiest way to understand these rules is to remember that a Roth IRA consists of two parts: (1) contributions/conversions and (2) investment gains/losses. This is important because contributions can always be withdrawn at any time, tax and penalty free. The earnings, however, are potentially taxable and could be hit with the early distribution penalty.

The Ordering Rules

Before jumping into the two 5-year rules and their examples, it’s important to understand the ordering rules for Roth IRA distributions. Thankfully, the IRS created the rules in a way that looks to benefit taxpayers. That is because the first dollars withdrawn are considered basis (contributions), which is always tax and penalty-free. If the distribution exceeds the Roth IRA basis, the excess is considered coming from converted funds, if any have taken place. With conversions, we use the oldest conversion first, thereby increasing the chance that the holding period (described below) has been met. Finally, any amount left over after the application of the first two tiers is considered earnings.

Conversion Rule

The first 5-year rule only applies to conversions and even then, only if the individual is under age 59 ½. It was adopted to prevent taxpayers from skirting the 10% early distribution penalty. For example, let’s say I have a traditional IRA and am under age 59 ½. If I take a distribution from this account, I pay taxes and trigger the 10% early distribution penalty. However, conversions do not trigger the 10% penalty. Thus, if this 5-year rule didn’t exist, I could convert all, or a portion of the traditional IRA to a Roth IRA, pay tax on the conversion, and then immediately take a distribution from the newly converted Roth IRA without triggering the penalty.

As a result, converted amounts are subject to the 10% early distribution penalty unless they were held for 5-years or the taxpayer is at least age 59 ½. Each conversion is subject to its own, separate, 5-year holding period.

Example: Melanie converts $50,000 to a Roth IRA in 2012 and another $60,000 to the same Roth account in 2014. She has not made any other contributions or conversions to the account. In 2018, at the age of 50, she takes an $80,000 distribution. Assuming no other exception to the 10% penalty applies, Melanie will owe the early distribution penalty on $30,000 (i.e., $3,000 tax). Under the ordering rules, $50,000 of the distribution is applied to her 2012 conversion, which has met its 5-year holding period. However, the remaining $30,000 is applied towards her 2014 conversion, which has not satisfied the 5-year rule. Thus, even though her withdrawal isn’t subject to income taxes, part of it will be subject to the 10% early distribution penalty.

Qualified Distribution Rule

The second 5-year rule mainly applies to earnings and determines whether a distribution is qualified, and therefore is tax and penalty free. A qualified distribution is one that paid after the 5-year holding period and: