Two Different 5-Year Rules for Roth IRA Distributions
One for tax-free distributions and one for penalty-free distributions
There are two different 5-year holding rules. The first 5-year rule is to determine if a Roth distribution is a qualified distribution and income tax free. The other 5-year rule applies only to conversions and only if the account owner is under 59½ years old. If they are under 59½ years old, they must hold the converted funds for five years. Distributions of converted funds not held for five years will be subject to the 10% penalty.
For the 10% Early Withdrawal Penalty Only (not for income tax)
This rule only applies to withdrawals of converted funds and only if the account owner is under 59½ years old when the converted funds are withdrawn. If the converted funds are not held for five years and the account owner is under 59½ years old, then withdrawals will be subject to the 10% penalty. The withdrawal will not be subject to income tax since income tax was paid when the funds were converted.
This 5-year rule can only apply to individuals under 59½ years old.
The five years begins on the first day of the year of each conversion. Unlike Roth contributions above, each conversion is a fresh start. If the conversion was done in 2007, the holding period for this second 5-year rule begins on January 1, 2007, even if the account owner had made a 1998 Roth contribution.
Congress thought the first 5-year rule was too easy to figure out so they created this monster to keep things in check. The best way to understand this 5-year rule is to see what it is set up to prevent. When money is taken out of a traditional IRA and converted to a Roth IRA, that distribution is treated as a rollover except that it is taxable. But like rollovers, it is not subject to the 10% early withdrawal penalty. Less than 20 seconds after this became law, the loophole lookouts started telling IRA owners how the Roth conversion could be used to beat the government out of the 10% penalty. If there was no Roth conversion and no withdrawals were made from an IRA before age 59½ the funds would be subject to the 10% penalty (unless an exception applied). The loophole was that if the account owner really did not want to convert, they could use the conversion as a way around the 10% penalty. Since there is no 10% penalty when funds are converted,the account owner could convert the IRA to a Roth IRA and then, the next day, withdraw funds from the Roth IRA tax and penalty free. IRS saw this as an abuse, and had Congress react fast. They created this 5-year rule that says if the converted funds are not held for at least five years, any withdrawal before that time would be subject to the 10% penalty the account owner would have paid if they withdrew from their traditional IRA. You cannot use the Roth as a conduit to beat the IRS out of the 10% penalty. For clients who are over 59½, this has no effect because they could have withdrawn from their traditional IRA penalty free anyway.
If the account owner is over 59½ and has held the account for more than five years, there are no distribution rules for a Roth IRA. They can withdraw as much as they want any time they want, which is one of the great beauties of this tax-free vehicle over other types of retirement plans.
For income tax only (not for the 10% penalty)
The five years begins on the first day of the year that the first Roth IRA was established for, even if the contribution was made after that year. A qualified distribution is one that is made after the five year holding period and age 59½ or is due to death, disability, or for a first time home purchase.
A 2012 Roth IRA contribution (annual contribution NOT a conversion) can be made upto April 15, 2013. Even if a taxpayer waits until April 15, 2013 (the last day to contribute to a 2012 Roth IRA), the 5-year clock begins on January 1, 2012. Roth contributions for the year are deemed to be made as of the first day of the year regardless of when thefunds were actually deposited for that year’s contribution.
Roth contributions for a year must be made no later than April 15th of the following year, even if the tax return is on extension. There is no extension beyond April 15th of the following year. This is also the rule for traditional IRA contributions.
The 5-year holding period starts when a client’s first Roth IRA account is established.
It does not re-start for each Roth IRA contribution or conversion
The holding period will start as of the first day of the tax year for which the first dollar of Roth IRA money is contributed, even if that first contribution is only $1.
If even $1 is contributed to a Roth IRA for 2008 and then in 2010, $50,000 was converted to the Roth IRA (same or different account – it does not matter because under the aggregation rules all Roth IRAs are considered one), then as of January 1, 2013, all the Roth money would be considered to have been held for five years for this 5-year rule. The key was that the Roth IRA 5-year clock began on the first day of the year for which the first dollar of Roth contributions was made.
If the account owner converted $20,000 to a Roth IRA at anytime in 2008 and that was the first money ever contributed or converted to a Roth IRA, the 5-year holding period begins on January 1, 2008 and ends on December 31, 2012. Assume the $20,000 is worth $25,000 after five years. If the account owner withdraws the $25,000 on January 1, 2013, she has held the Roth for the five years. If she is not yet 59½ on January 1, 2013, (and not dead, disabled or used the money for a first time home purchase) the $25,000 withdrawal is not a qualified withdrawal. The first $20,000 is not taxable because it is a return of the converted funds that were already taxed. The next $5,000 is the earnings and will be subject to income tax and a 10% penalty. For the earnings to be tax and penalty free, the Roth funds must also be held until the account owner is 59½ years old. If she was 59½ or older on January 1, 2013, then the entire $25,000 withdrawal will be tax and penalty free because it is a qualified distribution. She would have held the Roth for five years and until she was 59½ years old.