Roth Withdrawals and the 5 year rule

[VanWinkle]

I read this interesting article on the taxes and penalties on withdrawals from your Roth IRA. There is much confusion surrounding this, especially after doing conversions. Reaching age 59 1/2 changes many things about Roth withdrawals and penalties.

https://humbledollar.com/2020/05/gi..._medium=email&utm_campaign=another-ses-test_7

 

[kaneohe]

I like this table by kawill: The table is written in accordance w/ the ordering rules....contributions first, then conversions (oldest first and within each conversion, the taxable part first), then finally earnings. The table also makes clear that there are 2 types of 5 yr clocks........conversion clocks and age of first Roth clock. Once you turn 59.5, the conversion clock doesn't matter.

Re: Roth IRA Rules - Table Approach
Posted by: KAWill (IP Logged)
Date: October 14, 2010 11:57PM


Roth IRA Distribution Table

UNDER AGE 59.5
FIVE YEAR CONVERSION HOLDING PERIOD NOT MET

Contributions: Tax-No; Penalty-No
Conversions: Tax-No; Penalty-Yes (Taxable Portion)
Conversions: Tax-No ;Penalty-No (Nontaxable Portion)
Earnings: Tax-Yes; Penalty-Yes

UNDER AGE 59.5
FIVE YEAR CONVERSION HOLDING PERIOD MET

Contributions: Tax-No; Penalty-No
Conversions: Tax-No; Penalty-No (Taxable Portion)
Conversions: Tax-No; Penalty-No (Nontaxable Portion)
Earnings: Tax-Yes; Penalty-Yes

OVER AGE 59.5
LESS THAN FIVE YEARS SINCE OPENING FIRST ROTH IRA

Contributions: Tax-No ;Penalty-No
Conversions: Tax-No; Penalty-No (Taxable Portion)
Conversions: Tax-No; Penalty-No (Nontaxable Portion)
Earnings: Tax-Yes; Penalty-No

OVER AGE 59.5
FIVE YEARS OR MORE SINCE OPENING FIRST ROTH IRA

All Distributions Are Qualified

 

[VanWinkle]

I like this table by kawill: The table is written in accordance w/ the ordering rules....contributions first, then conversions (oldest first and within each conversion, the taxable part first), then finally earnings. The table also makes clear that there are 2 types of 5 yr clocks........conversion clocks and age of first Roth clock. Once you turn 59.5, the conversion clock doesn't matter.

Re: Roth IRA Rules - Table Approach
Posted by: KAWill (IP Logged)
Date: October 14, 2010 11:57PM


Roth IRA Distribution Table

UNDER AGE 59.5
FIVE YEAR CONVERSION HOLDING PERIOD NOT MET

Contributions: Tax-No; Penalty-No
Conversions: Tax-No; Penalty-Yes (Taxable Portion)
Conversions: Tax-No ;Penalty-No (Nontaxable Portion)
Earnings: Tax-Yes; Penalty-Yes

UNDER AGE 59.5
FIVE YEAR CONVERSION HOLDING PERIOD MET

Contributions: Tax-No; Penalty-No
Conversions: Tax-No; Penalty-No (Taxable Portion)
Conversions: Tax-No; Penalty-No (Nontaxable Portion)
Earnings: Tax-Yes; Penalty-Yes

OVER AGE 59.5
LESS THAN FIVE YEARS SINCE OPENING FIRST ROTH IRA

Contributions: Tax-No ;Penalty-No
Conversions: Tax-No; Penalty-No (Taxable Portion)
Conversions: Tax-No; Penalty-No (Nontaxable Portion)
Earnings: Tax-Yes; Penalty-No

OVER AGE 59.5
FIVE YEARS OR MORE SINCE OPENING FIRST ROTH IRA

All Distributions Are Qualified

I agree, I have the same table saved to my desktop!!

 

[jollystomper]

OVER AGE 59.5
FIVE YEARS OR MORE SINCE OPENING FIRST ROTH IRA

All Distributions Are Qualified

When I was working, our income was too high to qualify for Roth IRAs. Since retiring at 60, even though Roth conversions look for my situation to be a wash, this 5 year rule led me to open them for my spouse and I as soon as we were eligible, for future use down the road

 

[karen1972]

My only confusion had been if the 5 year clock started Jan 1 or Dec 31, this says Jan 1st which is great news as it means I can move all my withdrawals up a year. I'm 10+ years into my ROTH so that was never a concern but I was worried if I put money in Feb 2015, I wouldn't' actually be able to take it out until Jan 2021 which would be more like 5 years 11 months but this says I could take it out right now which is interesting.

 

[kaneohe]

When I was working, our income was too high to qualify for Roth IRAs. Since retiring at 60, even though Roth conversions look for my situation to be a wash, this 5 year rule led me to open them for my spouse and I as soon as we were eligible, for future use down the road

curious what you gain by doing this......since you are over 59.5 y.o. you could withdraw from TIRA any time w/o penalty.. Since you consider the Roth conversion to be a wash,what's the advantage?

 

[RunningBum]

curious what you gain by doing this......since you are over 59.5 y.o. you could withdraw from TIRA any time w/o penalty.. Since you consider the Roth conversion to be a wash,what's the advantage?

The money would be in a tax free account with a conversion, rather than in taxable with a withdrawal?

 

[kaneohe]

The money would be in a tax free account with a conversion, rather than in taxable with a withdrawal?

True, but that just meant taxes were paid in advance. OP did not give any indication that having taxable withdrawals in future would be a detriment.

Sometimes younger folks planning for future do a Roth conversion ladder.
Starting at perhaps 50, they convert something every yr. Then even tho they didn't previously have a Roth, starting at age 55, they can access the conversion (but not earnings) tax/penalty free which they could not do w/ TIRA. But this is not OP's situation since they are 60 .

 

[AtlasShrugged]

All,

I wrote the five-year rule article that appeared in the Humble Dollar referenced by the OP.

As a recent retiree, I was keen to understand the pros and cons of Roth conversions. I spent a fair amount of time researching them and then wrote myself a 10-page paper which I named, Roth Conversion Guide. This project helped me figure out what I wanted to do with conversions. I also gave my guide to several of my retired friends and family members who found it useful.

Given their positive reaction, I submitted it to Jonathan Clements at the Humble Dollar. While Jonathan liked it, it was too long for the articles he publishes on his site. He asked if I would turn two sections of it into two shorter articles. So I did. Besides the 5-year rule article, I also wrote an article called, To Roth or Not (link below). (BTW, he's a very nice guy.)

https://humbledollar.com/2020/05/to-roth-or-not/

I would be glad to share my full guide with anyone who would like a copy. I don't understand the mechanics of how to do that, but I suspect someone here could tell me how.

Rick

A few PSs:
I am not a salesman. I'm just a former financial weenie with an interest in Roth conversions and too much time on my hands. Also, I taught myself a lot about this subject, but I do not purport to be an expert.

Finally, my guide makes no recommendations as to what anyone should or shouldn't do. Its goal is to provide information to let readers come to their own conclusions.

 

[pb4uski]

Great article Rick. As you note, Roth conversions are principally a tax arbitrage play... pay some now to avoid paying more later. And if you pay with after-tax money then there is an additional tax benefit cherry on top.

The example that I like to use is that you have $100,000 in a tIRA and $25,000 in taxable account money and your tax rate is 25%.

If you convert and pay the 25% tax, your taxable account money is gone but you have $100,000 in your IRA... if it grows at 7% per year after 10 years you have $196,715 to spend.

If you don't convert and let each account grow at 7% for 10 years, the $100,000 tIRA grows to $196,715 and the $25,000 taxable account grows to $41,702... so if after 10 years you withdraw the $196,715 and pay the 25% tax of $49,179, you have $189,238 to spend.

Where does the $7,477 difference go? It goes to pay taxes each year on the growth in the taxable account over the 10 year investment time horizon*.

* [25,000 * (1+7%)^10] - [25,000 * (1+7%*(1-25%))^10] = $7,477

 

[VanWinkle]

All,

I wrote the five-year rule article that appeared in the Humble Dollar referenced by the OP.

As a recent retiree, I was keen to understand the pros and cons of Roth conversions. I spent a fair amount of time researching them and then wrote myself a 10-page paper which I named, Roth Conversion Guide. This project helped me figure out what I wanted to do with conversions. I also gave my guide to several of my retired friends and family members who found it useful.

Given their positive reaction, I submitted it to Jonathan Clements at the Humble Dollar. While Jonathan liked it, it was too long for the articles he publishes on his site. He asked if I would turn two sections of it into two shorter articles. So I did. Besides the 5-year rule article, I also wrote an article called, To Roth or Not (link below). (BTW, he's a very nice guy.)

https://humbledollar.com/2020/05/to-roth-or-not/

I would be glad to share my full guide with anyone who would like a copy. I don't understand the mechanics of how to do that, but I suspect someone here could tell me how.

Rick

A few PSs:
I am not a salesman. I'm just a former financial weenie with an interest in Roth conversions and too much time on my hands. Also, I taught myself a lot about this subject, but I do not purport to be an expert.

Finally, my guide makes no recommendations as to what anyone should or shouldn't do. Its goal is to provide information to let readers come to their own conclusions.

Rick,

OP here and thank you for chiming in on the original article. I have read your other linked article in the past and found it very helpful. As a person who went from a married couple to a single(widower) I can attest to your remarks about the value of conversions and the single tax brkt . I am now better able to control my yearly income due to prior Roth conversions.

Best to you,

VW

 

[AtlasShrugged]

Rick,

OP here and thank you for chiming in on the original article. I have read your other linked article in the past and found it very helpful. As a person who went from a married couple to a single(widower) I can attest to your remarks about the value of conversions and the single tax brkt . I am now better able to control my yearly income due to prior Roth conversions.

Best to you,

VW

Thanks for the kind words and sorry for your loss.

 

[GoGolfing]

Basic question - I'm converting $50k from traditional IRA to Roth IRA. I'm planning on paying the taxes out of our cash holdings. When do I need to pay those taxes? Immediately, or as part of our regular tax return in 2021? I'm concerned that there will be an IRS penalty for underpaying taxes during 2020.

 

[kaneohe]

Basic question - I'm converting $50k from traditional IRA to Roth IRA. I'm planning on paying the taxes out of our cash holdings. When do I need to pay those taxes? Immediately, or as part of our regular tax return in 2021? I'm concerned that there will be an IRS penalty for underpaying taxes during 2020.

How do you normally pay your taxes? If by withholding, it might be easier to just increase your withholding. https://fairmark.com/general-taxation/estimated-tax/how-much/
It would be useful if you know the safe harbor rules one of which is you withhold at least 100% of previous yr's taxes (110% if AGI was 150K or more),
you safe. If you normally pay by estimated tax, the same rule holds if you pay in 4 equal estimated quarterly payments (or faster).

 

[GoGolfing]

Thanks!!

How do you normally pay your taxes? If by withholding, it might be easier to just increase your withholding. https://fairmark.com/general-taxation/estimated-tax/how-much/
It would be useful if you know the safe harbor rules one of which is you withhold at least 100% of previous yr's taxes (110% if AGI was 150K or more),
you safe. If you normally pay by estimated tax, the same rule holds if you pay in 4 equal estimated quarterly payments (or faster).

We normally do withholding from our SS checks. Our taxable income is very low, but will be significantly higher this year and the next few years as we convert approximately 50k per year to finish the conversion. Safe harbor rule will help this year. The link you sent had great info.

 

[AtlasShrugged]

Basic question - I'm converting $50k from traditional IRA to Roth IRA. I'm planning on paying the taxes out of our cash holdings. When do I need to pay those taxes? Immediately, or as part of our regular tax return in 2021? I'm concerned that there will be an IRS penalty for underpaying taxes during 2020.

Your concern about under paying estimated taxes is well founded, because you are subject to that problem whether you pay taxes with cash from your tIRA or taxable account. As the previous poster said, you can bump your withholdings or make estimated tax payments throughout the year.

You don't have to pay taxes on the conversion immediately. That said, if you convert at year end, you can use the Annualized Income Installment Method (AIIM) and make one estimated tax payment by January 15th. AIIM is very complicated, but it allows you to defer estimated payments until January.

 

[kaneohe]

..................................

You don't have to pay taxes on the conversion immediately. That said, if you convert at year end, you can use the Annualized Income Installment Method (AIIM) and make one estimated tax payment by January 15th. AIIM is very complicated, but it allows you to defer estimated payments until January.

However, if you convert before yr end, you should either pay for that "quarter" or pay the 4 equal installments . The 4 equal installments will simplify your life. You might want to try the AIIM (Sch AI Form 2210) to see how it suits you........if easy, fine. https://www.irs.gov/pub/irs-pdf/f2210.pdf Sch AI is on the last pg.

 

[GoGolfing]

Thanks - great tip on AIIM

Your concern about under paying estimated taxes is well founded, because you are subject to that problem whether you pay taxes with cash from your tIRA or taxable account. As the previous poster said, you can bump your withholdings or make estimated tax payments throughout the year.

You don't have to pay taxes on the conversion immediately. That said, if you convert at year end, you can use the Annualized Income Installment Method (AIIM) and make one estimated tax payment by January 15th. AIIM is very complicated, but it allows you to defer estimated payments until January.

Thanks for the AIIM tip - wish I'd had that before - I would have waited until later in the year to move the $50k from the IRA to the Roth. I think we'll avoid the penalty this year because of our low taxes for 2019. And then will have to pay the quarterly estimated taxes next year. That will make for a painful April - paying taxes on 2020 and estimated quarterly tax for 2021.....

 

[RetireBy90]

Thanks for the AIIM tip - wish I'd had that before - I would have waited until later in the year to move the $50k from the IRA to the Roth. I think we'll avoid the penalty this year because of our low taxes for 2019. And then will have to pay the quarterly estimated taxes next year. That will make for a painful April - paying taxes on 2020 and estimated quarterly tax for 2021.....

I'm trying to convert a big chunk of the conversions early in the year so that any gain for that year will escape the tax man. If you plan to convert $50K and it earns say 6% or $3K and your say in 22% marginal bracket, then you could save $660 in taxes if converted 1 Jan as opposed to 31 Dec. Of course, your item being converted could decline in value throughout the year and a lower value would allow for the $50K to be a bigger portion of your tIRA but most years market goes up so playing the odds if you convert 1 Jan each year you should save in total tax bill on conversions.
One other consideration when doing Roth conversions, if you decide you want to make a big purchase lets say $250K, Maybe beach condo or a nice boat or whatever, and you take the funds from a tIRA all in one year, it could bump you into a higher effective tax rate. If you have converted to Roth over the years managing your tax hit, then you can take a big draw without having to worry about additional taxes.



Just one way to think about this.

 

[ocean view]

Glad to see this topic come up again as I have a related question for the collective wisdom. It concerns logistics to stay clean for the 5 year rule for Roth conversion re: principle withdrawals and whether they are penalty free or not. I understand that each conversion has a 5 tax-year clock that runs independently from the others conversions. I also understand the ordering rules (contributions, FIFO conversions, and then earnings). What I'm wondering is if folks doing annual conversions open a new account each year in order to better track the 5yr clock and their related earnings?

I've been opening new Roth accounts each year and I'm wondering if it's overkill (besides the additional work of more accounts/stmts to track). My concern stems from the situation in my tIRA where I co-mingled non-deductible contributions with regular tax deferred contributions back in my first years of work and now I am stuck allocating a tiny fraction of that previously taxed basis to my conversions. It's a pain in the butt. Is there anything similar for Roths?

I've done Roth conversions for 3 years, $50K per year, each of these will be 5 yrs old before I reach 59.5. I have no regular contributions to withdraw first. If I co-mingle and I need to withdraw Yr 1 principle in Yr 6, can I just withdraw $50K? Or do I need to allocate the total account balance among conversion years or some other method?

As I write this, it seems to make more sense that co-mingling is fine as long as the ordering rules are that ALL years of conversions are withdrawn before any earnings. My interpretation, or rather misinterpretation, is probably influenced by the ordering rules on the corporate side of tax where I'm familiar with the ordering rules for credits which are ordered by type and then by year generated.

 

[Brat]

It is my understanding that the 5-year test applies to the Roth itself, not to contributions. I am in my late 70s and am converting from tIRA to Roth from time to time. Our Roths are long-standing. I do not expect that the 5-year rule will apply to recent contributions.

 

[kaneohe]

It is my understanding that the 5-year test applies to the Roth itself, not to contributions. I am in my late 70s and am converting from tIRA to Roth from time to time. Our Roths are long-standing. I do not expect that the 5-year rule will apply to recent contributions.

Sounds like you are ancient as I am as is your Roth(>5 yrs old). If so see the table on the previous pg which shows that all distributions are qualified (no taxes or penalty) when withdrawn. If you are on ER.org, I would not think that you have had recent compensation that allows you to make contributions to the Roth tho you can certainly do conversions.

 

[Kwirk]

For clarity, consider changing the title of this thread from "rule" to "rules".

 

[Brat]

At this stage of my life I am doing conversions, back in the day (admittedly way back) they were contributions.