5 yr rule Roth conversions

[monte1022]

Per Kitces

"Accordingly, it’s also worth noting that because the 5-year rule for Roth conversions merely leaves the withdrawal of conversion principal potentially subject to the early withdrawal penalty, any other exceptions to the early withdrawal penalty can still shelter the Roth conversion amount from the penalty. Thus, withdrawals within 5 years of conversion by someone who is already over age 59 1/2 are not subject to the early withdrawal penalty, regardless of the 5-year conversion rule, simply because being over age 59 1/2 itself is an exception to the penalty!"

Per Business insider

"The 5-year rule on Roth conversions requires you to wait five years before withdrawing any converted balances — contributions or earnings — regardless of your age. If you take money out before the five years is up, you'll have to pay a 10% penalty when you file your tax return."

I know that we already had a thread discussing this, but I still do not understand. For example, if I convert 100k of my traditional 401k to a 5+year old Roth IRA at age 58, then per Kitces, I can access the converted amount without penalty as long as I am over 59.5 even though 5 yrs may not have passed yet? He does not mention anything about earnings.

However, Businessinsider says that age 59.5 is meaningless and only the passing of 5 years satisfies the rule to access converted amounts and earnings.

This board is full of folks well-versed in conversions. Can someone enlighten me please?

 

[jim584672]

I think there are two 5 year rules. One is that your Roth needs to be at least 5 years old. This means at least one of your Roth accounts needs to be open 5 years.

The 5 year rule for conversions for 59.5+ is once you are over 59.5 the 10% penalty doesn't apply, even if you converted less than 5 year ago, because age has eliminated the penalty.

 

[Dtail]

See post #2.

https://www.early-retirement.org/forums/f28/roth-withdrawals-and-the-5-year-rule-103986.html

 

[Whisper66]

Kaneohe has posted this easy to understand post several times over the years on these boards. I've found it the easiest to understand. See if this makes sense to you.....

"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"

 

[monte1022]

Thanks to all!

 

[mountainsoft]

Kaneohe has posted this easy to understand post several times over the years on these boards.

Awesome! I tried to write up something similar yesterday, but couldn't make sense of all the rules. This really helps spell it out much better than I could.

 

[Midpack]

The chart above is great - thank you. The only clarification I might add:

The five-year rule for Roth IRA withdrawals of investment earnings requires that you hold your account for at least five years before you can tap those earnings without incurring a penalty. It’s important to note this rule applies specifically to investment earnings. The contributions you’ve made can be withdrawn at any time because you’ve already paid taxes on this money.

Withdrawals of money from the conversion of a traditional IRA or 401(k) to a Roth IRA are subject to a five-year waiting period to avoid a penalty.

For this rule, the five-year period begins the first day of the tax year in which you converted money from a traditional IRA (or did a rollover from a qualified retirement plan) to your Roth IRA. For example, if you do a conversion in the month of May, the rule for that conversion begins on the prior Jan. 1. Each conversion or rollover you make is subject to a separate five-year waiting period.

 

[Animorph]

From: Publication 590-B (2019), Distributions from Individual Retirement Arrangements (IRAs)

https://www.irs.gov/publications/p590b#en_US_2019_publink1000231065

Distributions of conversion and certain rollover contributions within 5-year period. If, within the 5-year period starting with the first day of your tax year in which you convert an amount from a traditional IRA or roll over an amount from a qualified retirement plan to a Roth IRA, you take a distribution from a Roth IRA, you may have to pay the 10% additional tax on early distributions. You must generally pay the 10% additional tax on any amount attributable to the part of the amount converted or rolled over (the conversion or rollover contribution) that you had to include in income (recapture amount). A separate 5-year period applies to each conversion and rollover. See Ordering Rules for Distributions , later, to determine the recapture amount, if any.
The 5-year period used for determining whether the 10% early distribution tax applies to a distribution from a conversion or rollover contribution is separately determined for each conversion and rollover, and isn't necessarily the same as the 5-year period used for determining whether a distribution is a qualified distribution. See What Are Qualified Distributions? , earlier.

For example, if a calendar-year taxpayer makes a conversion contribution on February 25, 2019, and makes a regular contribution for 2018 on the same date, the 5-year period for the conversion begins January 1, 2019, while the 5-year period for the regular contribution begins on January 1, 2018.

Unless one of the exceptions listed later applies, you must pay the additional tax on the portion of the distribution attributable to the part of the conversion or rollover contribution that you had to include in income because of the conversion or rollover.

You must pay the 10% additional tax in the year of the distribution, even if you had included the conversion or rollover contribution in an earlier year. You must also pay the additional tax on any portion of the distribution attributable to earnings on contributions.

Other early distributions. Unless one of the exceptions listed below applies, you must pay the 10% additional tax on the taxable part of any distributions that aren't qualified distributions.
Exceptions. You may not have to pay the 10% additional tax in the following situations.
You have reached age 59½.
You are totally and permanently disabled.
You are the beneficiary of a deceased IRA owner.
You use the distribution to buy, build, or rebuild a first home.
The distributions are part of a series of substantially equal payments.
You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income (defined earlier) for the year.
You are paying medical insurance premiums during a period of unemployment.
The distributions aren't more than your qualified higher education expenses.
The distribution is due to an IRS levy of the qualified plan.
The distribution is a qualified reservist distribution.
Most of these exceptions are discussed earlier in chapter 1 under Early Distributions .

 

[monte1022]

The chart above is great - thank you. The only clarification I might add:

So, if I put Midpack's and Animorph's posts together I get something like this. Each conversion amount has its own 5yr waiting period and dipping into the funds prior to meeting the rule means penalties and perhaps a tax on any earnings. However, if you happen to turn 59.5 sometime BEFORE the 5yr period is finished then you can escape ANY penalties or taxes. Furthermore, any conversions occurring after age 59.5 DO NOT require ANY waiting period at all since being over 59.5 is an exception. Right?

 

[Genug]

The chart above is great - thank you. The only clarification I might add:

So how do you keep track of each conversation for the 5 year rule as it pertains to earnings? Is each conversion held in its own account?
I am over 59 1/2 and it looks like Roth conversions would be kind of a push for me. The 5 year rule makes me lean towards not doing conversions

 

[EastWest Gal]

It seems that all you need to do is not take out more than what you converted five years ago. Once the money is in the account, it's in the account. If you move assets directly into the Roth, your brokerage and your statements will have a record of what you moved and when. Is this correct?

 

[SecondCor521]

So how do you keep track of each conversation for the 5 year rule as it pertains to earnings? Is each conversion held in its own account?
I am over 59 1/2 and it looks like Roth conversions would be kind of a push for me. The 5 year rule makes me lean towards not doing conversions

It isn't necessary or useful to hold each conversion in it's own account.

The IRS considers all traditional IRAs collectively, and similarly all Roth IRAs are considered collectively, so from a tax standpoint having more than one doesn't matter.

Also, the amount eligible to be withdrawn five years later is the dollar amount of the earlier contribution, not whatever that dollar amount invested in the Roth happens to grow or shrink to. So if you convert $5,000 five years ago, today you can withdraw exactly $5,000 even if it was invested in Tesla and is now worth $1M, or even if you made bad decisions in GME and it's now worth $1K.

The proper way to do it is for the taxpayer to maintain the relevant records. The amounts converted should be shown in box 3 on Form 5498s and/or on a properly prepared Form 8606 Sections II and III.

 

[corn18]

So how do you keep track of each conversation for the 5 year rule as it pertains to earnings? Is each conversion held in its own account?
I am over 59 1/2 and it looks like Roth conversions would be kind of a push for me. The 5 year rule makes me lean towards not doing conversions

It takes care of itself. Earnings are always taken out last. The piece that was missing from the previous table is the ordering rules:

ORDER OF DISTRIBUTIONS
Regular contributions
Taxable portion of first conversion
Nontaxable portion of first conversion
Each subsequent conversion, in order, with the taxable portion coming out first for each conversion
Earnings (any increase in value occurring inside the Roth IRA)

When you make a withdrawal from a Roth IRA, it comes out in this order. All of the earnings are commingled and come out last, so you don't need to worry about where they came from.

 

[SecondCor521]

It seems that all you need to do is not take out more than what you converted five years ago. Once the money is in the account, it's in the account. If you move assets directly into the Roth, your brokerage and your statements will have a record of what you moved and when. Is this correct?

This could work, but you'd have to distinguish between Roth contributions and Roth conversions, since the tax treatment of those two differ.

 

[CRLLS]

In addition to Kaneohe's post, I also like the flow chart from www.irs.gov/publications/p590b. For those >59.5 yrs it provides a quick answer. For those <59.5 it is not as detailed as Kaneohe's.

 

[Midpack]

So how do you keep track of each conversation for the 5 year rule as it pertains to earnings? Is each conversion held in its own account?
I am over 59 1/2 and it looks like Roth conversions would be kind of a push for me. The 5 year rule makes me lean towards not doing conversions

I haven't done any Roth withdrawals yet so I may be mistaken.

There's no need to keep separate accounts. You know the $ converted, and the ending balance for each year - that gives you what you can withdraw after each 5 year period. If you don't have them, your brokerage would have those records or you can get a transcript from the IRS as a last resort. Conversion amounts are taken first (including prior years if applicable), then earnings (including prior years if applicable). TurboTax keeps track of all that and provides a running history of same for users (other tax software may do the same). If you're converting more annually than you expect to take out, it's not likely to be an issue.

 

[intent]

So how do you keep track of each conversation for the 5 year rule as it pertains to earnings? Is each conversion held in its own account?
I am over 59 1/2 and it looks like Roth conversions would be kind of a push for me. The 5 year rule makes me lean towards not doing conversions

If I'm understanding your question and situation correctly, and understanding the different 5-year-rules correctly (two big IFs), I think, because you are over 59.5, you don't have to concern yourself with tracking the conversions.

From my understanding (and someone please correct me if I have this wrong):

If you are over 59.5 and you opened your first Roth account more than 5 years prior, all of your withdrawals are qualified (i.e., tax- and penalty-free). So, even if you converted funds from a tIRA to your Roth when you were 58, as soon as you hit 59.5 all of the converted funds and any earnings on those funds become tax- and penalty-free.

Example for a person who turns 59.5 in Jan 2021:

• Opened first Roth account in 2015 with $1K contribution (more than 5 years ago)
• Converted $5K from tIRA to Roth in 2020 (less than 5 years ago)
• Total amount in Roth has grown to $7K ($1K initial contribution + $5K conversion + $1K earnings)
• Could withdraw the entire $7K and pay no penalty and no tax today (because they have met the first 5-yr-rule related to when they opened their first Roth account, and the second 5-yr-rule related to conversions no longer applies because they are over 59.5)

The conversion penalty only applies if you withdraw funds prior to 59.5. I believe this is the case because the 5-yr-rule related to conversions exists to prevent people from gaining immediate, penalty-free access to tIRA funds. Once you have reached 59.5, you have immediate, penalty-free access to tIRA funds, so there is no longer any reason to make someone wait an additional 5 years to access funds converted from a tIRA to a Roth account.

 

[gauss]

Since you are talking about traditional 401ks and Roth IRAs in the same post, I will offer my strategy on this since that is similar to my current situtaiton.

#1) Perform a partial "in-plan" 401k conversion from trad 401k to Roth 401k if your plan allows it.

#2) Your employer will calculate the "taxable amount" for you on the 1099-R for this transaction that will be issued the following January. In many cases, the entire amount converted would be taxable (ie assuming no after-tax non-Roth contributions) My 1099-R coded this with a Code G in box 7.

#3) Perform a direct rollover from the Roth 401k to a Roth IRA.
This should generate a separate 2nd 1099-R for this transaction. I received a $0 taxable amount and a code H in box 7. Note the figure in Box 5 Employee contribution/Designated Roth contribution or insurance premiums. This is the "investment in the contract" portion described in IRS form 8606 for tracking Roth IRA contribution basis. By adding this figure to line 22 on 8606 this amount should be available for immediate withdrawal from your Roth IRA without 10% penalty.

This technique will allow you to get a significant amount into a Roth IRA quickly which is available for immediate withdrawal. This strategy involves a non-qualified Roth IRA distribution of contributions so there is no requirement to be age 59 1/2 nor have a Roth IRA open for 5 years. Also, since you are not distributing any IRA "conversions" the whole business about waiting 5 years before withdrawing a conversion also does not apply.

The trick is that you will need a 401k plan that has a Roth 401k option that allows partial conversions. (Note there is a question that I did not address here regarding if the Roth 401k needs to be in place for 5 years -- I think the answer is no, but I would need to research that further).

You will also, of course, need to pay tax on the amount converted from trad 401k to Roth 401k in the year of the conversion.

As always, I would recommend that if you adopt this strategy:

#1) Read the tax forms and your 401k plan rules to ensure that my assumptions apply to your particular case

#2) Perhaps only process a small amount ie $1,000 the first year and then verify that it is all handled as you expect by your custodians (ie 1099-Rs) and your tax software. In the second year you should have the confidence to ramp up the amount converted.

#3) Don't forget to either send in estimated tax payments if you do this in the early to mid year, or handled the tax due via W2 and/or 1099-R withholding.

If anyone sees any flaws in any of this, I would welcome the feedback.

-gauss

 

[gauss]

Although you touched on this in your prior paragraphs, I added some clarifying language to make this explicit in your final summarizing paragraph.

-gauss

The conversion penalty only applies if you withdraw funds prior to 59.5 (or your first Roth IRA was opened less than 5 years ago) . I believe this is the case because the 5-yr-rule related to conversions exists to prevent people from gaining immediate, penalty-free access to tIRA funds. Once you have reached 59.5 (and your first Roth IRA has been in place for at least 5 years), you have immediate, penalty-free access to tIRA funds, so there is no longer any reason to make someone wait an additional 5 years to access funds converted from a tIRA to a Roth account.