Quick Roth Conversion Tax ?

[fritz]

I originally asked if the penalties and taxes SecondCor521 was referring to applied to those under 59.5. I went on to describe if not - why I then found the ordering rules to conflict with the 5 year rules.

I thought the "separate" 5 year rules for Roth contributions and Roth conversions were in place to govern what was a qualified distribution and a non-qualified distribution.

Distributions from a Roth account that was open for 5 years from the 1st contribution, came under a qualified distribution - providing the owner was over 59.5 years of age. All contributions and "earnings" were qualified distributions and not subject to penalties or taxes.

Distributions from a Roth account that affected any Roth "conversions" were considered qualified distributions - if that specific Roth conversion's 5 year timer had lapsed. All contributions and "earnings" from that specific Roth conversion were then qualified distributions and not subject to penalties or taxes.

I also thought the ordering rules really come into play when the Roth account distribution goes beyond what's considered qualified distributions and then becomes a non-qualified distribution.

Non-qualified distributions would be -

After all qualified contributions/earnings were taken from a +5 year old Roth account, along with all contributions/earnings from conversions older than 5 years.

If this is correct - only the non-qualified contributions and then earnings would follow the ordering rules and be subject to taxes and penalties.

As I see it - that would leave Roth conversions that had yet to meet their 5 year rule timers in place.

My separating Roth conversions in funds over 5 years in my original post, was for tracking simplicity of the 5yr timers (for heirs, should I pass while the timers are active).

 

[SecondCor521]

I also thought the ordering rules really come into play

My understanding is that ordering rules are always in play. Always. It doesn't matter your age. It doesn't matter whether it's an originally owned or inherited IRA. It doesn't matter how long you've had a Roth IRA. It also doesn't matter if you like the ordering rules or agree with them or not. It also doesn't matter whether you've made contributions or conversions or both. The ordering rules are always in play.

All contributions and "earnings" from that specific Roth conversion were then qualified distributions and not subject to penalties or taxes.

I'm not sure how you're assigning meaning to the terms qualified and unqualified. The IRS doesn't use such language, so I think it's confusing to introduce it.

I think what may be messing up your understanding is referenced in the above quote. It seems that you want to associate a given Roth conversion with its subsequent earnings inside the Roth. This is not how the IRS sees it, and it's what I've been trying to say (apparently not that successfully) in my previous posts.

So let me try again.

Assume you start with a Roth with $0 in it that you opened in 2015.

If you convert $10K into your Roth this year, then two things will happen. First, you add $10K to your gross income which will show up on your 2021 Form 1040 line 4b. Second, you can take $10K out of your Roth on 1/1/2026 or later tax- and penalty-free.

If you take that $10K and use it to buy an investment that grows to $17K, then the additional $7K is considered earnings by the IRS and goes into the third bucket.

And per the ordering rules, you can't take that $7K out of that third bucket until you take out everything in the first bucket (contributions) and everything out of the second bucket (conversions). Even if, in your head, they're connected because they happen to be the same mutual fund shares inside the Roth - again, the IRS doesn't care about what happens inside your Roth. They do not connect dollars with investments.

So to specifically respond to the above sentence of yours that I quoted:

1. If the original Roth owner is under 59.5, the earnings on a particular Roth conversion do not become penalty-free just because the conversion amount itself has become qualified by way of the 5-year holding period.

2. If the original Roth owner is over 59.5, the conversions and earnings are (as MikePiper helpfully confirmed, above) penalty-free regardless of the 5-year conversion timer. (I think the other 5-year rule applies, though, so you'd have had to have had a Roth account opened at least five years.)

3. If the original owner has died, the conversions and earnings are (again, hat tip to Mike Piper for confirming above) again penalty-free regardless of the 5-year timer. (The other 5-year rule does apply, according to the MarketWatch article above; Mike Piper seems to say the opposite, but I think he's referring to the 5-year conversion timer rule, not the have-a-Roth-open-five-years-ago rule.)

Since we're getting rather detailed and it's possible we may continue to talk past each other, I might suggest that you present the most simple concrete example illustrating your question or point. Then we could probably tell you with reference to that example what's up.

 

[Mike Piper]

Contributions come out tax-free, penalty-free at any time.

Conversions come out free from regular income tax at any time. There is, however, a 10% penalty unless:
a) the 5-year rule has been met for that conversion,
b) the distribution is for a qualifying reason, or
c) one of the other exceptions provided in 72(t) applies.

As far as earnings:
1) they are tax-free and penalty-free if there is a qualifying reason and the 5-year rule has been met;

2) they are taxable as income but not subject to the 10% penalty if
2a) the distribution is for a qualifying reason but you have not met the 5-year rule or
2b) the distribution is not for a qualifying reason but one of the other exceptions in 72(t) applies;

3) they are taxable as income and subject to 10% penalty if the distribution was not for a qualifying reason and none of the other exceptions to the 10% penalty from 72(t) is applicable.

Qualifying reasons:
a) you are age 59.5,
b) you are disabled,
c) you are deceased and the distribution is being paid to the account's beneficiary or to your estate, or
d) the distribution is a "qualified first-time homebuyer distribution."

 

[fritz]

Contributions come out tax-free, penalty-free at any time.

Conversions come out free from regular income tax at any time. There is, however, a 10% penalty unless:
a) the 5-year rule has been met for that conversion,
b) the distribution is for a qualifying reason, or
c) one of the other exceptions provided in 72(t) applies.

As far as earnings:
1) they are tax-free and penalty-free if there is a qualifying reason and the 5-year rule has been met;

2) they are taxable as income but not subject to the 10% penalty if
2a) the distribution is for a qualifying reason but you have not met the 5-year rule or
2b) the distribution is not for a qualifying reason but one of the other exceptions in 72(t) applies;

3) they are taxable as income and subject to 10% penalty if the distribution was not for a qualifying reason and none of the other exceptions to the 10% penalty from 72(t) is applicable.

Qualifying reasons:
a) you are age 59.5,
b) you are disabled,
c) you are deceased and the distribution is being paid to the account's beneficiary or to your estate, or
d) the distribution is a "qualified first-time homebuyer distribution."

I believe you stated the same things I did (post #123), only I used more of the king's English to to say it.

 

[fritz]

My understanding is that ordering rules are always in play. Always. It doesn't matter your age. It doesn't matter whether it's an originally owned or inherited IRA. It doesn't matter how long you've had a Roth IRA. It also doesn't matter if you like the ordering rules or agree with them or not. It also doesn't matter whether you've made contributions or conversions or both. The ordering rules are always in play.



I'm not sure how you're assigning meaning to the terms qualified and unqualified. The IRS doesn't use such language, so I think it's confusing to introduce it.

I think what may be messing up your understanding is referenced in the above quote. It seems that you want to associate a given Roth conversion with its subsequent earnings inside the Roth. This is not how the IRS sees it, and it's what I've been trying to say (apparently not that successfully) in my previous posts.

So let me try again.

Assume you start with a Roth with $0 in it that you opened in 2015.

If you convert $10K into your Roth this year, then two things will happen. First, you add $10K to your gross income which will show up on your 2021 Form 1040 line 4b. Second, you can take $10K out of your Roth on 1/1/2026 or later tax- and penalty-free.

If you take that $10K and use it to buy an investment that grows to $17K, then the additional $7K is considered earnings by the IRS and goes into the third bucket.

And per the ordering rules, you can't take that $7K out of that third bucket until you take out everything in the first bucket (contributions) and everything out of the second bucket (conversions). Even if, in your head, they're connected because they happen to be the same mutual fund shares inside the Roth - again, the IRS doesn't care about what happens inside your Roth. They do not connect dollars with investments.

So to specifically respond to the above sentence of yours that I quoted:

1. If the original Roth owner is under 59.5, the earnings on a particular Roth conversion do not become penalty-free just because the conversion amount itself has become qualified by way of the 5-year holding period.

2. If the original Roth owner is over 59.5, the conversions and earnings are (as MikePiper helpfully confirmed, above) penalty-free regardless of the 5-year conversion timer. (I think the other 5-year rule applies, though, so you'd have had to have had a Roth account opened at least five years.)

3. If the original owner has died, the conversions and earnings are (again, hat tip to Mike Piper for confirming above) again penalty-free regardless of the 5-year timer. (The other 5-year rule does apply, according to the MarketWatch article above; Mike Piper seems to say the opposite, but I think he's referring to the 5-year conversion timer rule, not the have-a-Roth-open-five-years-ago rule.)

Since we're getting rather detailed and it's possible we may continue to talk past each other, I might suggest that you present the most simple concrete example illustrating your question or point. Then we could probably tell you with reference to that example what's up.

I took the definitions from this info -

https://www.irs.gov/retirement-plans/designated-roth-accounts-distributions

 

[SecondCor521]

I took the definitions from this info -

https://www.irs.gov/retirement-plans/designated-roth-accounts-distributions

You were right on this; I stand corrected. Thank you.

ETA: However, that page seems to be describing Roth 401(k) accounts, not Roth IRAs. Although the two share the name and a general approach of after-tax contributions and tax-free growth, the tax treatment of the two account types are different in some ways.

I would not assume that anything you read about a Roth 401(k) applies to a Roth IRA or vice versa.

Everything I've been writing on this thread has been assuming Roth IRAs, not a Roth 401(k). I think Mike Piper was also making the same assumption.

 

[fritz]

You were right on this; I stand corrected. Thank you.

ETA: However, that page seems to be describing Roth 401(k) accounts, not Roth IRAs. Although the two share the name and a general approach of after-tax contributions and tax-free growth, the tax treatment of the two account types are different in some ways.

I would not assume that anything you read about a Roth 401(k) applies to a Roth IRA or vice versa.

Everything I've been writing on this thread has been assuming Roth IRAs, not a Roth 401(k). I think Mike Piper was also making the same assumption.

I've seen these qualified/non-qualified Roth distributions references in other online articles.

https://smartasset.com/retirement/roth-ira-qualified-distribution

But you stated the IRS didn't use it, and I recalled seeing it on their website recently (the other link - post #130).

Please understand - I'm not looking to disagree with anyone posting here. Apologize if it's coming across that way.

I'm planning on implementing everything I've posted on this thread, this year (possible multiple Roth conversions, custodian withholding federal taxes, placing that tax amount withheld into my Roth (separate fund) within the 60-day rule with funds from another source, and placing yearly Roth conversions in my Roth account in separate funds for tracking each conversion's 5 year timer). I was running my plan by members here (for comments/corrections) to see if my ducks are all in a row - for the most part.

No one responded when i asked if anyone could confirm if my Roth conversion strategy was correct (post #103) when it was questioned by a friend of mine knowledgeable in finance, so I searched and found a credible answer. I posted what I found here (post #116) for everyone who's following the thread. I included the credible references they gave as well.

My harebrained idea for tracking the 5 year rule timers on yearly Roth conversions seemed logical (to me). I was pretty sure that the way I looked at Roth account distributions on contributions, conversions, and earnings as it related to qualified and non-qualified for taxes and penalties was close to being right. Mike Piper's post (#128) appears to corroborate my post #126

 

[SecondCor521]

I've seen these qualified/non-qualified Roth distributions references in other online articles.

https://smartasset.com/retirement/roth-ira-qualified-distribution

But you stated the IRS didn't use it, and I recalled seeing it on their website recently (the other link - post #130).

Please understand - I'm not looking to disagree with anyone posting here. Apologize if it's coming across that way.

I'm planning on implementing everything I've posted on this thread, this year (possible multiple Roth conversions, custodian withholding federal taxes, placing that tax amount withheld into my Roth (separate fund) within the 60-day rule with funds from another source, and placing yearly Roth conversions in my Roth account in separate funds for tracking each conversion's 5 year timer). I was running my plan by members here (for comments/corrections) to see if my ducks are all in a row - for the most part.

No one responded when i asked if anyone could confirm if my Roth conversion strategy was correct (post #103) when it was questioned by a friend of mine knowledgeable in finance, so I searched and found a credible answer. I posted what I found here (post #116) for everyone who's following the thread. I included the credible references they gave as well.

My harebrained idea for tracking the 5 year rule timers on yearly Roth conversions seemed logical (to me). I was pretty sure that the way I looked at Roth account distributions on contributions, conversions, and earnings as it related to qualified and non-qualified for taxes and penalties was close to being right. Mike Piper's post (#128) appears to corroborate my post #126

No worries here. I'm mainly trying to make sure I present accurate information and secondarily to try to help you. If I'm not being helpful, feel free to tell me to stop trying.

I will say that in your response I think that you emphasized a relatively minor part of my post #127 (about IRS terminology) and ignored the main point of it (how the IRS treats conversion earnings). I'm still not convinced that you understand my main point, especially since you reiterate again that you plan to track your 5 year timers with different investments in your last paragraph in the above quoted section.

Here's the main point that I'm not sure you're getting:

"Assume you start with a Roth with $0 in it that you opened in 2015.

If you convert $10K into your Roth this year, then two things will happen. First, you add $10K to your gross income which will show up on your 2021 Form 1040 line 4b. Second, you can take $10K out of your Roth on 1/1/2026 or later tax- and penalty-free.

If you take that $10K and use it to buy an investment that grows to $17K, then the additional $7K is considered earnings by the IRS and goes into the third bucket.

And per the ordering rules, you can't take that $7K out of that third bucket until you take out everything in the first bucket (contributions) and everything out of the second bucket (conversions). Even if, in your head, they're connected because they happen to be the same mutual fund shares inside the Roth - again, the IRS doesn't care about what happens inside your Roth. They do not connect dollars with investments."

 

[fritz]

No worries here. I'm mainly trying to make sure I present accurate information and secondarily to try to help you. If I'm not being helpful, feel free to tell me to stop trying.

I will say that in your response I think that you emphasized a relatively minor part of my post #127 (about IRS terminology) and ignored the main point of it (how the IRS treats conversion earnings). I'm still not convinced that you understand my main point, especially since you reiterate again that you plan to track your 5 year timers with different investments in your last paragraph in the above quoted section.

Here's the main point that I'm not sure you're getting:

"Assume you start with a Roth with $0 in it that you opened in 2015.

If you convert $10K into your Roth this year, then two things will happen. First, you add $10K to your gross income which will show up on your 2021 Form 1040 line 4b. Second, you can take $10K out of your Roth on 1/1/2026 or later tax- and penalty-free.

If you take that $10K and use it to buy an investment that grows to $17K, then the additional $7K is considered earnings by the IRS and goes into the third bucket.

And per the ordering rules, you can't take that $7K out of that third bucket until you take out everything in the first bucket (contributions) and everything out of the second bucket (conversions). Even if, in your head, they're connected because they happen to be the same mutual fund shares inside the Roth - again, the IRS doesn't care about what happens inside your Roth. They do not connect dollars with investments."

Everything you've re-stated here from your original post, I agreed with. When you stated the IRS didn't use qualified and non-qualified distribution terminology, I just referenced where I saw it (IRS) for the followers of this thread, and it was not meant to call you out on it. I've seen this terminology used for Roth conversions in other online places.

As for the ordering rules - I put together my post #126 regarding what was qualified and non-qualified for a Roth distributions, from my understanding of the information from several online references (two of them).

https://www.investopedia.com/terms/o/orderingrules.asp

https://www.doughroller.net/retirement-planning/the-5-year-rule-on-roth-ira-conversions/

My understanding (and for simplicity) is that qualified distributions - those that meet both of the 5 year rules (for contributions/earnings, and conversions/earnings), may be withdrawn penalty and tax free. The ordering rules place those funds within the Roth as penalty and tax free for distribution, once the 5 year rules are both met (if in fact you have done any Roth conversions).

It stands to reason that the 5 year rule for contributions/earnings on Roths comes first - that the account has to be open for 5 years and the person must be over the age of 59.5. I also understand that you may have more than one Roth account, but as long as one account has been open for 5 years and you are over 59.5 years of age, you've also met the 5 year rule (the IRS sees your accounts as one).

The 5 year rule on distributions from Roth conversions is an additional rule that applies to all conversions - where the conversions/earnings are considered qualified distributions after each conversion's 5 year timer has lapsed, the 5 year rule for contributions/earnings would have also been met.

I did state the ordering rules really come into play (post #126) after all qualified distributions were withdrawn (again, following the ordering rules).

I also thought the ordering rules really come into play when the Roth account distribution goes beyond what's considered qualified distributions and then becomes a non-qualified distribution.

As I see it, the taxes and penalties (and the IRS) come into play with non-qualified distributions, and follow the ordering rules for taxes and penalties on contributions/earnings (first 5 year rule), and then contributions/earnings on Roth conversions (2nd 5 year rule - if in fact you've done any).

The twist here (as I understand it) is that contributions and conversions (amounts that were taxed already), would not be subject to taxes again. Penalties could be incurred if you were not 59.5 years of age, or the 5 year timer had not lapsed on affected conversions. Earnings (following the ordering rule) could also be subject to ordinary taxes.

I've read there are special considerations for penalties and taxes that are applicable in certain circumstances, but I don't want to bring them up here as this is confusing enough to me.

 

[pb4uski]

Well.... after considering the quantity and length of the last dozen or so posts in this thread, I have concluded that the thread title of "Quick Roth Conversion Tax?" is totally misleading.

 

[SecondCor521]

OK. @fritz, I can't tell if we're agreeing or if we're talking past each other. In either case, it seems to make sense for me to drop it, so I will. I appreciate the conversation.

 

[cat4ever]

Way ahead of you PB (which I'm sure is a first for me):

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

Actually I think the terms "quick" and "Roth Conversion ?" should never be in the same sentence together.

 

[fritz]

I wanted to follow up on this thread with some additional information I've gotten on the (2) Roth 5 year rules. I was mistakenly looking at the (2) 5 year rules as uniquely applied to the two different areas of Roth IRA accounts - contributions and earnings, and conversions and their earnings.

The order is - 1st 5 year rule is used, and if not met, the 2nd 5 year rule (which only applies penalties to Roth conversion amounts - not taxes on earnings) is used.

The 1st Roth 5 year rule applies to contributions, conversions, and earnings. To withdraw funds (contributions, conversions, and earnings - in that ordering rule), without any contributions/conversions penalties and taxes on earnings - generally your Roth account has to be open for 5 years, and you must be older than 59.5 years of age.

There are other portions of the 1st 5 year rule specifically relating to exceptions that would allow you to withdraw funds without meeting the requirements, but don't want to confuse this with my original inquiry here. (see link below)

The 2nd Roth 5 year rule only comes into play on conversions, if you have not met the 1st 5 year rule's requirements (Roth account older than 5 years, and being older than 59.5). This would apply penalties on the conversion amounts, if the conversion had not lapsed its 5 year timer. Any conversions earnings come under the 1st 5 year rule (following the ordering rule).

Again, there are other portions of the 2nd 5 year rule that relate to specific exceptions for the rule, but don't want to confuse this with my original inquiry. (again, see link below)

Long story short - if you are older than 59.5 and at least (1) of your Roth accounts is older than 5 years, the 2nd 5 year rule does not apply. You will not be penalized or taxed on withdrawals from your Roth account. All contributions, conversions, and earnings (following the ordering rules) are considered qualified distributions.

I obtained this information from Mike Kitces. He also references his article from January 2014 for further clarification of the (2) 5 year Roth IRA Rules.

https://www.kitces.com/blog/underst...s-for-roth-ira-contributions-and-conversions/