Saturday, June 21, 2008

Understanding 5-Year Rule for Roth Withdrawals

I am over 59½ and am planning to convert my traditional IRA to a Roth IRA over the next several years. Will each conversion start a new five-year clock? Will I have to track the investments each year so I can separate out the conversion amount from the earnings on each yearly conversion?

--John Low Meredith, N.H.
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I have been considering converting a large portion of my regular IRA to a Roth IRA. All the contributions were pretax; I am 71 and have assets outside my IRA to pay the taxes.

Both my IRA custodian and IRS Publication 590 seem to indicate that I must wait five years for any tax-free withdrawal from the Roth IRA. But if I read your column correctly, I can withdraw principal at any time if I am over 59½, and only have to wait five years before taking out any income. Can you point me to any definitive articles or rules that can resolve this issue?

--Bert Mochel, Morrison, Colo.

Our recent answers to questions about Roth IRA contributions sparked a new round of questions about the so-called five-year rule -- the amount of time you generally must have a Roth individual retirement account open before you can withdraw earnings tax-free. Your age, and whether you're making an original contribution or are converting assets from a traditional IRA, affect the way it works.

In a nutshell, you can withdraw your original contributions to a Roth at any time with no tax or penalty. The five-year clock for earnings on regular contributions starts the year you open your first Roth IRA, and it doesn't reset each time you make a contribution or open another Roth, says Ed Slott, an IRA consultant in Rockville Centre, N.Y. (If you opened a Roth between Jan. 1 and April 15 of 2008, for example, as a 2007 account, the five-year clock would start Jan. 1, 2007.) You also have to turn 59½ years old to avoid a 10% penalty for early withdrawals on any earnings, along with income tax.

The five-year rule works a bit differently for assets you convert to a Roth IRA from other IRAs: You have to hold those assets in a Roth for five years or until you turn 59½, whichever comes first, to make penalty-free withdrawals of your converted amounts. Each conversion has its own five-year clock.

But if you've already reached age 59½ and you convert traditional IRA assets to a Roth, you can withdraw the assets you convert at any time without worrying about a five-year deadline or penalties. It's a different story with any earnings on those assets: Again, you have to have held a Roth account for five years to withdraw any earnings tax-free. But you don't need to worry about separating the converted funds from the earnings, since the withdrawal rules for Roth IRAs say that any distributions first come from contributions, then from conversions, and finally from earnings, Mr. Slott says.

What about the reader in the second question above? Again, withdrawals of converted Roth assets are always tax-free. To withdraw the earnings tax-free, you have to hold the Roth IRA for five years (and be at least 59½). The reader above, who is 71, simply has to have the Roth IRA open for five years to withdraw all the funds tax-free, Mr. Slott says.

One note: Since you are 71, you are required to take minimum distributions each year from your traditional IRA. Those distributions can't be converted to a Roth IRA. In the year you wish to convert, you must first withdraw your required distribution, and then you can convert any or all remaining funds to a Roth. Remember, to qualify for a Roth conversion, your modified adjusted gross income must be no more than $100,000 a year, either for an individual or married couple filing jointly. Starting in 2010, there are no income limits for Roth conversions. Neither your required minimum distributions nor the funds converted to the Roth would count toward that $100,000 income limit -- but they do still count as taxable income, says Mr. Slott.

IRS Publication 590 at is the most comprehensive source of information about IRAs. On page 65 -- in the section titled, "Are Distributions Taxable?" -- the first sentence indicates that distributions of contributions -- including converted amounts -- aren't taxable. The next section, "Additional Tax on Early Distributions," addresses the assessment of the 10% early distribution penalty -- and implies that you are able to withdraw converted amounts at any time, says Mr. Slott. And on page 67, the "Ordering Rules for Distributions" section spells out that contributions come out first, then converted amounts, then earnings.

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