Quick Roth Conversion Tax ?

[pb4uski]

I'm pretty sure that we have talked about that before in other threads.

 

[fritz]

I like "the fritz method". I wish I'd thought if it.

I can't take credit for it, as it was discussed off and on in this thread.

I did think it is a great way to avoid estimated quarterly tax payments, and the complications of Form 2210 (uneven income justification to avoid tax penalties).

Also for income streams where I could not or did not withhold enough Federal taxes (ie. Taxable account dividends at Banks/Vanguard where they don't allow tax withholding). This has happened to me on the state level as mentioned in my earlier post. And what a real PITA it was to resolve (and not my fault).

There is a real catch22 scenario where well thought out tax planning withholding can go out the window, when you decide to make a significant move with your investments. What you need to think about is how it will affect your taxable income in prior quarters. You can't go back and make or redo your prior quarterly estimated tax payments (a real gotcha). Having Vanguard withhold Federal taxes on my Roth conversions, and the IRS considering them evenly spread across the year will go a long way towards avoiding that pitfall.

Edit/add: I was a little slow in hitting the post button with my reply..

 

[fritz]

Ok, a little curve ball on this method of IRA to Roth conversion.

Spoke with a person who told me that he didn't think that you could do more than one conversion per year utilizing this method.

The issue isn't that you can't do more than one IRA to Roth conversion during the year and have Vanguard withhold/pay the Federal tax to the IRS.

It's that you technically took a cash distribution (the taxes), and put that amount in the Roth (from another source) within the 60 day window allowed - which would fall under the once per year rollover rule. As such you would be limited to one in a 365 day period.

Long story short (if he's right), multiple conversions utilizing this method would not be allowed - only one per year...

It would be hard to verify multiple conversions this way IMHO, as I believe Vanguard reports your conversions/taxes as one lump sum on your tax forms. An IRS audit might bring out the issue.

Would appreciate any input on this issue from forum members using this method. Anyone doing multiple Roth conversions and having their investment company withhold/pay their Federal taxes, and putting that amount in their Roth within the 60 day window from another source?

 

[cat4ever]

Ok, a little curve ball on this method of IRA to Roth conversion.

It's that you technically took a cash distribution (the taxes), and put that amount in the Roth (from another source) within the 60 day window allowed - which would fall under the once per year rollover rule. As such you would be limited to one in a 365 day period.

So you're saying the contribution that covers the withdrawal amount isn't considered part of the Roth Conversion but some other kind of rollover, so it is subject to the one rollover per year rule? Doing this wouldn't preclude additional "direct" Roth conversions or rollovers in the 365 day window where this method wasn't used, right? (sorry, I'm still coming to terms with some of the terminology).

I'm planning on doing a Roth 401K to Roth IRA conversion soon, which shouldn't involve any taxes or withholding, I hope I haven't precluded that now.

 

[pb4uski]

Ok, a little curve ball on this method of IRA to Roth conversion.

Spoke with a person who told me that he didn't think that you could do more than one conversion per year utilizing this method.

The issue isn't that you can't do more than one IRA to Roth conversion during the year and have Vanguard withhold/pay the Federal tax to the IRS.

It's that you technically took a cash distribution (the taxes), and put that amount in the Roth (from another source) within the 60 day window allowed - which would fall under the once per year rollover rule. As such you would be limited to one in a 365 day period.

Long story short (if he's right), multiple conversions utilizing this method would not be allowed - only one per year...

It would be hard to verify multiple conversions this way IMHO, as I believe Vanguard reports your conversions/taxes as one lump sum on your tax forms. An IRS audit might bring out the issue.

Would appreciate any input on this issue from forum members using this method. Anyone doing multiple Roth conversions and having their investment company withhold/pay their Federal taxes, and putting that amount in their Roth within the 60 day window from another source?

Actually, that makes sense that the taxes withheld are really a withdrawal rather than a conversion...IOW let's say you do a $10k conversion and have $2k withheld so only $8k ends up in the Roth... in substance you have a $8k Roth conversion and a $2k withdrawal.

I'm not even sure if you can deposit the $2k directly to the Roth but perhaps you can... technically I think it is a $2k rollover contribution back into the tIRA with a simultaneous $2k Roth conversion. The reason that I'm thinking that is because you can't just willy nilly add money to a Roth... it needs to be a contribution or a conversion and if you just deposited $2k directly it would not seem to be either... but perhaps they view it substantively as a acceptable shortcut to redepositing the money to the tIRA and then converting it to the Roth.

All of that said, I'm not sure why one would want to do multiple conversions a year even to begin with.

 

[pb4uski]

So you're saying the contribution that covers the withdrawal amount isn't considered part of the Roth Conversion but some other kind of rollover, so it is subject to the one rollover per year rule? Doing this wouldn't preclude additional "direct" Roth conversions or rollovers in the 365 day window where this method wasn't used, right? (sorry, I'm still coming to terms with some of the terminology).

I'm planning on doing a Roth 401K to Roth IRA conversion soon, which shouldn't involve any taxes or withholding, I hope I haven't precluded that now.

Yes to the first question and no to the second.

IOW you can do as many straight up Roth conversions with no withholding as you want... just like you can do as many tIRA trustee-to-trustee transfers as you want.

But you can only do one withdrawal and roll it over in 12 months... whether that is a straight up withdrawal where you get a check into your grubby little hands and then replace the withdrawal within 60 days or the more stealthy version where you have taxes withheld as part of a Roth conversion and then later replace the money in the Roth.

On the last part, if your conversion will be a trustee-to-trustee transfer or a plan-to-IRA rollover then you should be all set.

https://www.irs.gov/retirement-plan...vers-of-retirement-plan-and-ira-distributions

 

[fritz]

So you're saying the contribution that covers the withdrawal amount isn't considered part of the Roth Conversion but some other kind of rollover, so it is subject to the one rollover per year rule? Doing this wouldn't preclude additional "direct" Roth conversions or rollovers in the 365 day window where this method wasn't used, right? (sorry, I'm still coming to terms with some of the terminology).

I'm planning on doing a Roth 401K to Roth IRA conversion soon, which shouldn't involve any taxes or withholding, I hope I haven't precluded that now.

I understood it to mean that when Vanguard converts the IRA to the Roth, it codes the funds going directly into the Roth as one transaction, and the funds that go to the Feds for taxes as another (cash).

It was the replacement of the taxes (cash) amount from the IRA sent to the Feds, that you deposit in the Roth from another source within the 60 day window that was a rollover transaction subject to the one per year rule.

It he's correct - it would limit Roth conversions of that nature to one per year. Any additional conversions within the 365 days would have to be -

100% to Roth conversions (no taxes withheld) - with timely payments of estimated taxes to the Feds,

or -

Partial Roth conversions where the portion withheld and coded for taxes (cash) would not be able to be redeposited into the Roth by you from another source.
​

I guess I can live with doing one Roth conversion per year, with the replacement of the taxes (cash) within the 60 day window - or paying estimated quarterly taxes on additional Roth conversions where 100% of conversion went directly into the Roth - or losing the ability to replace the tax (cash) amount on additional conversions.

Hopefully someone here with hands-on experience doing Roth conversions, who is replacing the portion coded/withheld for Federal taxes (cash) paid on your behalf, can verify how to do it properly.

Edit/add - man I'm slow at composing-posting responses. pb4's answer verifies that it does fall under the one per year rule....

 

[sengsational]

My MO is to first "do my taxes" in December, then do the Roth conversion, so once a year would be fine. But it would be a timing PITA to not do it on day 364 or something.

 

[gauss]

The way way that I understand it is, I think, that you can do multiple Roth conversions if they are all considered direct transfers.

The issue, I suspect, is that when the conversion is implemented via a 60-day rollover where you take possession of the cash (Tax withholding would fall into this category.). When you try to replace the cash within 60 days you are using one of your rollovers.
In this case you make likely run afoul of the 1 per year rollover rule because this strategy was using a rollover to implement a Roth Conversion.

Personally, I still have funds in a 401k, so hopefully if I need a second rollover, I could accomplish that via a 401k --> IRA 60-day rollover that is not limited to once per year.

-gauss

 

[fritz]

The way way that I understand it is, I think, that you can do multiple Roth conversions if they are all considered direct transfers.

The issue, I suspect, is that when the conversion is implemented via a 60-day rollover where you take possession of the cash (Tax withholding would fall into this category.). When you try to replace the cash within 60 days you are using one of your rollovers.
In this case you make likely run afoul of the 1 per year rollover rule because this strategy was using a rollover to implement a Roth Conversion.

Personally, I still have funds in a 401k, so hopefully if I need a second rollover, I could accomplish that via a 401k --> IRA 60-day rollover that is not limited to once per year.

-gauss

I believe you could pull off a 2nd Roth conversion with Vanguard withholding/paying Federal taxes and replacing it within the 60 day window (a rollover under the one per year rule), if you are married and your spouse has their own IRA/Roth accounts. Kind of a way around the rule using his/her accounts for the 2nd conversion, as it's not the same person/accounts (a team strategy for planning purposes). Would see the one with the largest balance 1st, and the top off with the lower one. You could plan the conversions 6mos apart for timing optons.

 

[calnomore]

I did a Roth conversion in Dec 2020 and had the taxes withheld. I want to do a rollover in Jan 2021 to put that money into the Roth.
Does it matter if you did the conversion in 2020 and the rollover in 2021?

I'm having trouble getting someone at Schwab that understands. I think the best so far (maybe the correct way?) is to put the money into the tIRA and then do another conversion with that amount. This would be done in 2021. Does that create an issue since I did the original one in 2020?

 

[SecondCor521]

I did a Roth conversion in Dec 2020 and had the taxes withheld. I want to do a rollover in Jan 2021 to put that money into the Roth.
Does it matter if you did the conversion in 2020 and the rollover in 2021?

No, as long as the rollover happens within 60 days of the conversion.

I'm having trouble getting someone at Schwab that understands. I think the best so far (maybe the correct way?) is to put the money into the tIRA and then do another conversion with that amount. This would be done in 2021. Does that create an issue since I did the original one in 2020?

You can only put money into your tIRA if you have enough earned income and meet all of the other contribution rules.

If you're just trying to replace the tax withholding, it's probably better to just put the money into your Roth IRA and ask them to code it as an indirect rollover contribution. Schwab certainly knows how to do that.

 

[calnomore]

Just talked to two more people in Schwab's retirement department. Still a no-go. They can't figure out a way to put the amount of the withheld taxes into the Roth.
I guess next time I'll have to do quarterly taxes. Very disappointed.

 

[cathy63]

Did you use the words "indirect rollover"? Don't confuse them by explaining where you got the money or that it was related to tax withholding. The only thing they need to know is that you took it out of an IRA and now you want to roll it over into a Roth and you've had it less than 60 days.

 

[calnomore]

I stated "indirect rollover" too many times. Still nothing.

 

[fritz]

[FONT=Arial, sans-serif]I wanted to follow up my original post regarding Roth Conversions and placing the Federal Taxes withheld into the original Roth conversion account within the 60-day window rule - and possibly doing multiple Roth conversions during the year in the same manner.[/FONT]

[FONT=Arial, sans-serif]I searched for clarification of those questions, and posting what I’ve found by someone knowledgeable on the subject (Andy Ok’d posting of his replies). I would add that some others’ responses were “that’s above my pay grade”, and “you’ll need to ask to a tax advisor” (from a tax advisor). These were places where people go for tax information, so really makes one wonder about getting credible tax advice. This was the question(s) as worded to all inquiries - [/FONT]

[FONT=Arial, sans-serif]Roth Conversion Tax Question - (retired individual)

I wish to make a Roth conversion (Rollover IRA to my Roth) this year.

I wish to have my Custodian Financial Institution withhold Federal taxes on the Roth conversion, as they are considered paid over the entire year when withheld/paid by them. This would eliminate doing quarterly estimated tax payments, and possibly avoid penalties for any quarter with insufficient withholding - or filing Form 2210 to address uneven income/avoid penalties.

I would like to put the Federal tax withholding amount on the Roth conversion (paid by my Custodian Financial Institution on my behalf) into my Roth within the "60 day window rule", with funds obtained from another source. Understand this is allowable.

Would this be considered a "rollover" of the Federal tax withholding amount put into the Roth from another source (within the allowable 60 day window)?

If the replacement of the Federal tax withholding is considered a "rollover", does it fall into the "One Per Year Rule"?[/FONT]

[FONT=Arial, sans-serif]I found this article “Roth Conversions: Paying Taxes from Another Source By Andy Ives”. I decided to ask Andy if he could clarify my tax question.[/FONT]

[FONT=Arial, sans-serif]This is the link to the article (Ed Slott and Company LLC) - [/FONT]

[FONT=Arial, sans-serif]https://www.irahelp.com/slottreport/roth-conversions-paying-taxes-another-source[/FONT]

[FONT=Arial, sans-serif]This is what caught my eye regarding taxes paid on the article, and was included with the question(s) as listed above - [/FONT]

[FONT=Arial, sans-serif]Read this article and have a question about the scenario mentioned below...

Example: Jonathan is 45 years old and handles all his financial affairs on-line with no professional guidance. After logging into his account, he converts $50,000 to a Roth IRA and elects to have 20% withheld for taxes. Jonathan’s conversion results in only $40,000 going to the Roth ($50,000 x 80% = $40,000). The 20% withheld for taxes ($10,000) never actually gets converted and is, technically, a withdrawal prior to the conversion.[/FONT]

[FONT=Arial, sans-serif]This was Andy’s reply - [/FONT]

[FONT=Arial, sans-serif]What you are proposing is allowed, and is a wise move based on your estimated tax rationale. The taxes withheld on your conversion can then be “replaced” from another source so as to make the Roth conversion “whole.” This replacement of funds must be done within the 60-day window.

[/FONT] [FONT=Arial, sans-serif]As for your second question, the replacement of the withheld taxes into the new Roth IRA does not count as a rollover. As long as those dollars are put into the Roth IRA, they will be considered a Roth conversion. As such, that conversion transaction will not count against the one-rollover-per-year rule. There is no limit to how many Roth conversions you can do in a year. (Hypothetically, if those replacement dollars were put back into a Traditional IRA, it would be a rollover and count toward the one-per-year rule.)[/FONT]

[FONT=Arial, sans-serif]I thanked Andy and asked if he would provide the reference to the tax rule and he came back with a link to this information -[/FONT]

…[FONT=Arial, sans-serif].if you want to get into the weeds and look, it is Reg. §1402c-2, in the Q&A, Answer 11, third sentence. This section talks about rolling over the withheld taxes with replacement dollars, but doing the same replacement within 60 days to make the Roth conversion “whole” is interpreted by us to fall under the same umbrella rule.[/FONT]

[FONT=Arial, sans-serif]Here is the reference link:[/FONT]
[FONT=Arial, sans-serif]https://www.law.cornell.edu/cfr/text/26/1.402(c)-2[/FONT]

[FONT=Arial, sans-serif]([/FONT][FONT=Arial, sans-serif]This is the specific reference for the [/FONT][FONT=Arial, sans-serif]1[/FONT][FONT=Arial, sans-serif]402c-2, in the Q&A, Answer 11, third sentence[/FONT][FONT=Arial, sans-serif])[/FONT]

[FONT=Arial, sans-serif]Q-11: If an eligible rollover distribution is paid to an employee, and the employee contributes all or part of the eligible rollover distribution to an eligible retirement plan within 60 days, is the amount contributed not currently includible in gross income?[/FONT]

[FONT=Arial, sans-serif]A-11: Yes, the amount contributed is not currently includible in gross income, provided that it is contributed to the eligible retirement plan no later than the 60th day following the day on which the employee received the distribution. If more than one distribution is received by an employee from a qualified plan during a taxable year, the 60-day rule applies separately to each distribution. [/FONT][FONT=Arial, sans-serif]Because the amount withheld as income tax under section 3405(c) is considered an amount distributed under section 402(c), an amount equal to all or any portion of the amount withheld can be contributed as a rollover to an eligible retirement plan within the 60-day period, in addition to the net amount of the eligible rollover distribution actually received by the employee.[/FONT][FONT=Arial, sans-serif] However, if all or any portion of an amount equal to the amount withheld is not contributed as a rollover, it is included in the employee's gross income to the extent required under section 402(a), and also may be subject to the 10-percent additional income tax under section 72(t). See § 1.401(a)(31)-1, Q&A-14, for guidance concerning the qualification of a plan that accepts a rollover contribution.[/FONT]

[FONT=Arial, sans-serif]Apologize for the length of reply, but felt shortening it up might result in not conveying the inquiry and responses clearly.[/FONT]

 

[cat4ever]

Fritz, thanks so much for following up on all of this, I think I'm going to copy you reply into my taxes folder for reference just in case there's any flack from the IRS. It will be interesting to see how it all plays out for me and I'll respond back here if there's any hiccups, but it certainly looks like you've nailed it all down here.

I'm thinking the original subject of this thread is quite a misnomer, wish there were a way to change it.

 

[fritz]

Fritz, thanks so much for following up on all of this, I think I'm going to copy you reply into my taxes folder for reference just in case there's any flack from the IRS. It will be interesting to see how it all plays out for me and I'll respond back here if there's any hiccups, but it certainly looks like you've nailed it all down here.

I'm thinking the original subject of this thread is quite a misnomer, wish there were a way to change it.

I don't mind telling you that I heard conflicting feedback, but no one was sure about the right answers. I can also tell you that the conflicting info came from sources that handle this specific scenario, but none had looked at it as I presented it (custodian paying taxes, replacing the taxes withheld directly into the Roth within the 60 day rule, and being able to do it multiple times in the year).

It left me feeling very uncomfortable proceeding with my plan, as I was worried that if this was not very common, that even an IRS auditor might not know and might subject me to some form of penalty that wasn't clearly referenced in the Roth Conversion Rules.

I asked if anyone here was a tax expert and could shed some like on the subject (reply #103 here), but no one responded to that inquiry - so I pursued the answer on my own.

I did ask Andy for references to the actual rule - do to all the weakness with the responses, and Andy came back quickly with the original ruling reference presented by Cornell Law School.

Let's hope that Andy/Ed Slott's Group (the IRA Experts regularly on PBS), and Cornell Law School's publication on Rollover Distributions is enough to convince a newbie IRS auditor you did it properly.

 

[fritz]

On this thread there are also questions on the 5 year rule for conversions. I understand that the IRS sees Roth conversions as FIFO (first in - first out), and co-mingling of funds really isn't an issue (as they see it). But I plan on doing Roth conversions annually until it's all converted, or the other scenario happens. Plans might change if the govt. tax game board changes (again), but have to go the direction dealt currently.

Given "you" have a 5 year time frame for any Roth conversion withdrawals w/o 10% in penalties (and being +59.5 yrs age) - I thought to do annual Roth conversions into my existing Roth account, and place each year's conversion funds into a specific separate Mutual fund for the 5 years. This would be for isolating the conversions for timing and preventing commingling of conversion funds and earnings. I see this as important for heirs, as the 5 year rule is not forgiven upon the death of the original owner, but understand the 10% penalty is forgiven for all heirs.

Also understand heirs would be responsible for taxes on "earnings only" for all withdrawals of conversions not meeting the 5 year rule. This could affect up to five conversions under timers. Spouse has the rollover option, and my children/grandchildren beneficiaries (not falling under the special circumstances for stretch IRA rules) have 10 years to remove the funds.

They have the option of holding the funds until the original 5 year timers are met, or paying taxes on the earnings since the conversions. Holding them in separate funds until the 5 year timers are met should greatly simplify things for them tax-wise, should the other scenario happen and my heirs (other than my spouse) inherit the account. Am I looking at this correctly?

 

[cat4ever]

I feel pretty confident in the additional rollover of the amount equal to the withheld taxes as the guy that set it up mentioned that he would need to label it correctly as part of a rollover and said he'd been through the process before.

As for the one year rule I'm not too worried about it as I hadn't done any indirect rollovers in the last year and can wait for a year before I try to do a similar one in 2021.

 

[Mike Piper]

A forum member emailed me to ask if I would reply to this thread.

The thread relates to the idea of doing a Roth conversion and having federal income tax withheld and then within the 60-day window depositing from other sources the amount withheld into the Roth as an "indirect rollover". So for example, one would do a $10k Roth conversion with $2k withheld in federal income tax and then within the 60 day window deposit $2k of money from other sources into the Roth... so $10k ends up out of the tIRA, $10k ends up in the Roth and $2k is paid in tax to the feds.

The nuance of a difference between doing this and just a $10k Roth conversion with no withholding and separately making a $10k estimated payment is that the $10k withheld is considered as having been paid ratably over the year for prepayment penalty purposes.

I agree that using other assets to essentially make the conversion "complete" within 60 days is fine -- the whole amount will count as having been converted.

And yes, the amount withheld will count as having been paid over the course of the year.


As far as references for the 60-day option, here's a relevant Treasury Regulation. (Of note, it refers to a MAGI limitation which no longer exists.)
https://www.law.cornell.edu/cfr/text/26/1.408A-4


Here are the referenced 408A(e) and 408(d)(3)
https://www.law.cornell.edu/uscode/text/26/408A#e
https://www.law.cornell.edu/uscode/text/26/408#d_3


IRS Publication 590a mentions the concept as well.
https://www.irs.gov/publications/p590a#en_US_2019_publink1000230658

 

[SecondCor521]

On this thread there are also questions on the 5 year rule for conversions. I understand that the IRS sees Roth conversions as FIFO (first in - first out), and co-mingling of funds really isn't an issue (as they see it). But I plan on doing Roth conversions annually until it's all converted, or the other scenario happens. Plans might change if the govt. tax game board changes (again), but have to go the direction dealt currently.

Given "you" have a 5 year time frame for any Roth conversion withdrawals w/o 10% in penalties (and being +59.5 yrs age) - I thought to do annual Roth conversions into my existing Roth account, and place each year's conversion funds into a specific separate Mutual fund for the 5 years. This would be for isolating the conversions for timing and preventing commingling of conversion funds and earnings. I see this as important for heirs, as the 5 year rule is not forgiven upon the death of the original owner, but understand the 10% penalty is forgiven for all heirs.

Also understand heirs would be responsible for taxes on "earnings only" for all withdrawals of conversions not meeting the 5 year rule. This could affect up to five conversions under timers. Spouse has the rollover option, and my children/grandchildren beneficiaries (not falling under the special circumstances for stretch IRA rules) have 10 years to remove the funds.

They have the option of holding the funds until the original 5 year timers are met, or paying taxes on the earnings since the conversions. Holding them in separate funds until the 5 year timers are met should greatly simplify things for them tax-wise, should the other scenario happen and my heirs (other than my spouse) inherit the account. Am I looking at this correctly?

I think mostly so, with one major note of caution.

When determining contributions and conversions with IRAs, the IRS looks at dollars, not how those dollars are invested inside the accounts.

Suppose you do a Roth conversion of $10,000 in 2021 and put it all in mutual fund X. Five tax years later in 2026, suppose the value of those mutual fund shares is now $17,000. You may only withdraw $10,000 (the dollar value of the conversion in 2021) from your Roth IRA tax- and penalty-free, not the $17,000 (the value to which the investment had grown). The additional $7,000 worth of shares would be considered earnings, which are last in the Roth ordering rules and would come out order-wise after any 2022, 2023, 2024, and 2025 Roth conversions, and would be subject to penalties and maybe taxes if withdrawn before 59.5.

 

[fritz]

I think mostly so, with one major note of caution.

When determining contributions and conversions with IRAs, the IRS looks at dollars, not how those dollars are invested inside the accounts.

Suppose you do a Roth conversion of $10,000 in 2021 and put it all in mutual fund X. Five tax years later in 2026, suppose the value of those mutual fund shares is now $17,000. You may only withdraw $10,000 (the dollar value of the conversion in 2021) from your Roth IRA tax- and penalty-free, not the $17,000 (the value to which the investment had grown). The additional $7,000 worth of shares would be considered earnings, which are last in the Roth ordering rules and would come out order-wise after any 2022, 2023, 2024, and 2025 Roth conversions, and would be subject to penalties and maybe taxes if withdrawn before 59.5.

Being subject to taxes and penalties on earnings withdrawals applies to when you're under the age of 59.5?

If I understand your stated withdrawal order process (IRS) -

The only thing available to someone doing yearly Roth conversions (after the 5 year timer is satisfied) is the initial conversion amount. The earnings on that conversion come out in the order the IRS follows as if all conversions were commingled. The IRS would follow the FIFO order (first in - first out) for contributions/conversions, and then any earnings follow (last) in the order of things.

Following this withdrawal order process - you would never be able to access any Roth contributions/conversions earnings until all of your conversions had lapsed their 5 year timers?

If you were doing yearly Roth conversions (even with required RMDs) to level out your IRA's future RMD annual withdrawals (reducing the amount of your RMDs as you age) - you'd never be able to access any earnings on any of your Roth contributions/conversions, until the last Roth conversion's 5 year timer had lapsed? (This may be five years after your death.)

Our Roth accounts are decades old (and we're over the age of 59.5), and without any past/current Roth conversions - all of the funds (including earnings) are available for withdrawal.

If we should do any Roth conversions into those accounts - your stating that those contributions/conversions earnings would then be frozen for for tax-free accessing, until all Roth conversion 5 year timers have lapsed?

If doing yearly Roth conversions - your heirs would have to wait until the last Roth conversion's timer had lapsed, to access any/all earnings w/o incurring federal taxes?

I don't recall coming across any verbiage on the 5 year rule regarding earnings on all Roth conversions (and contributions) being inaccessible for tax-free withdrawal until all Roth conversion 5 year timers have lapsed.

Appreciate if you would point out where this information is accessible online. Really hamstrings Roth conversions..

 

[SecondCor521]

^ The rules are complicated, and I think you still have some misunderstandings.

The rules depend on when you opened your first Roth IRA, and whether or not you are past age 59.5. The rules may also depend on whether it is an inherited Roth IRA. I understand the rules far enough to apply them to my own situation; beyond that I'll point you to the IRS website for further information.

For original owners of a Roth IRA and setting aside inherited Roth IRAs for a minute:

The easiest way to understand it is that there are three buckets: contributions, conversions, and earnings. Contributions are the dollar amounts you put into your Roth IRA. Conversions are the dollar amounts you converted, usually from a traditional IRA. Earnings are all the dollars that are not contributions or conversions.

Inside your Roth IRA, the IRS totally does not care what you bought when, or how much, or if there are dividends, or interest, or capital appreciation or depreciation. Reread the previous paragraph - they only care how many dollars you put in, how many dollars you converted in, and the rest of the dollars are earnings.

You can have any number of Roth IRAs and make contributions and conversions to any of them. From the IRS' point of view, they treat all your Roth IRAs as one giant Roth IRA.

When money is removed from the Roth IRA, the IRS deems that contributions come out first. Contributions are not taxed and are not penalized ever. Contributions are deemed to be removed in FIFO order.

Once all contributions to the Roth IRA have been removed, then the IRS deems that conversions come out second, again in FIFO order. Conversions that have rested in the Roth IRA for five tax years can be removed tax- and penalty-free, even if you are under 59.5.

I am not sure if one can remove conversions faster than the five year timeline implies without penalty after age 59.5. It may be so.

If you withdraw enough fast enough to where you are withdrawing conversion amounts before they have rested for five years, I am not sure what happens exactly but I think the 10% penalty applies. If you want to call that "frozen", I suppose you could, but I wouldn't think of it that way - the money is accessible, there may just be penalties due.

After you have removed all contribution amounts and conversion amounts, then the IRS deems that you are taking out earnings (that's the only thing left). Earnings removed before age 59.5, as I noted before, may be subject to taxes and penalties. I am 99.9% certain that earnings removed after age 59.5 and five years after your first Roth IRA was opened are both tax and penalty free.

Note the following things about the ordering rules:

1. The IRS sets the ordering rules, and you can't elect differently.
2. The IRS ordering rules actually happen to usually be the approach most people would want to follow anyway.
3. The IRS ordering rules don't care about what happens inside your Roth IRA. There is no sort of tracing of investments. So if you make a contribution in year 1 and buy stock X with your contribution dollars, and then a conversion in year 2 and buy stock Y, then make a withdrawal in year 3, the IRS doesn't care if you sell stock Y to fund the withdrawal; it will be considered a withdrawal of the contributions from year 1 because contributions come out before conversions.

For inherited Roth IRAs, I believe that the ordering rules still apply but that there may be relief from the 10% penalty if the original owner had opened their Roth IRA more than five years ago and was over 59.5 when they passed away. I think this Marketwatch article is reasonably understandable and is probably accurate: https://www.marketwatch.com/story/if-i-inherit-a-roth-ira-are-the-distributions-taxed-2021-01-21

For where this is available online, I would point you to the instructions for IRS Form 8606, which are located at https://www.irs.gov/pub/irs-pdf/i8606.pdf. Roth withdrawals, in particular, are covered in part III of that form. The five year rule is sort of hidden in the basis calculation for line 24 of that form. These instructions are very complicated because they have to deal with a lot of scenarios which I have left out.

(*) Assuming you don't have any basis in your traditional IRA. If you have a basis in your traditional IRA, it's probably because you made non-deductible contributions at some point. There are ordering rules for these as well, but I don't know what they are, because this situation does not apply to me.

 

[Mike Piper]

SecondCor521, you have written an excellent explanation. Just providing confirmation of a few points, below.

I am not sure if one can remove conversions faster than the five year timeline implies without penalty after age 59.5. It may be so.

Yes, after reaching age 59.5, converted amounts can come out penalty-free regardless of the 5-year window.

If you withdraw enough fast enough to where you are withdrawing conversion amounts before they have rested for five years, I am not sure what happens exactly but I think the 10% penalty applies. If you want to call that "frozen", I suppose you could, but I wouldn't think of it that way - the money is accessible, there may just be penalties due.

That's correct. The money is accessible. And it would not be subject to ordinary income tax. It would be subject to the 10% penalty, unless the distribution is for a qualifying reason (e.g., you are age 59.5, deceased, or disabled) or the distribution meets one of the other exceptions to the 10% penalty (e.g., it's used to pay for qualifying higher education expenses).

IRC 408A(d) and 72(t) are relevant here:
https://www.law.cornell.edu/uscode/text/26/408A#d
https://www.law.cornell.edu/uscode/text/26/72#t_

After you have removed all contribution amounts and conversion amounts, then the IRS deems that you are taking out earnings (that's the only thing left). Earnings removed before age 59.5, as I noted before, may be subject to taxes and penalties. I am 99.9% certain that earnings removed after age 59.5 and five years after your first Roth IRA was opened are both tax and penalty free.

Yep.

For inherited Roth IRAs, I believe that the ordering rules still apply but that there may be relief from the 10% penalty if the original owner had opened their Roth IRA more than five years ago and was over 59.5 when they passed away.

The 10% penalty is waived simply because the owner has passed away and the distribution is being made to the beneficiary or to the owner's estate. Doesn't matter if the 5-year rule was met, nor does the deceased owner's age matter.

See 72(t)(2)(A)(ii)
https://www.law.cornell.edu/uscode/text/26/72#t_