If you’re one of many investors contributing to a Roth IRA or considering a Roth Conversion for an existing pre-tax retirement account, it’s important to understand exactly how the “Five Year Rule” works. Below is a short explanation of how the rule affects your IRA distributions.
The five year Roth rule refers to a five-year period that restricts tax-free distributions on the earnings/gains in a Roth IRA and distributions of converted funds in a Roth IRA. If a Roth IRA achieves gains in addition to the contribution amount(s), distributions of those gains before the five-year waiting period AND before the account holder turns 59.5 years of age will be taxable and potentially subject to additional penalties. Similarly, funds that are converted from a “pre-tax” retirement plan to a Roth IRA must wait five years to be distributed tax-free. The five-year period begins when an IRA holder opens a Roth IRA and begins making contributions OR when a new Roth conversion is performed. In either event, the actual effective date of the five-year Roth rule is always backdated to January 1 of the tax year the event takes place. This can be important because if you time things right, your wait time can actually be reduced by more than 20%. Let’s take a look at some math below to get a clearer understanding.
New Roth IRA Example: If I start a Roth IRA in April 2012 (remember to backdate) and begin making annual contributions beginning in the tax year of 2011, my five-year time clock will have ended on January 1, 2016. Notice that my effective wait time was less than four years, not five. My wait period begins January 1, 2011, not April 2012.
Traditional to Roth Conversion Example: If I have an existing Traditional IRA, it’s possible for me to perform a Roth conversion. To perform this process, I pay tax on the amount being converted in order to change my retirement funds from “pre-tax” to “post-tax”. I claim the converted amount on my tax return for the tax year in which I perform the conversion. Once I start this process, the five-year rule begins. Just like before, the later in the year I perform my conversion, the more my five-year rule becomes a four-year wait.
It’s important to note that I must perform my conversion before December 31st or the tax year will effective change. For example, if I’d like my conversion to represent the tax year of 2012, I must complete my 2012 conversion before December 31st, 2012. Conversions made between January 1 – April 15th cannot be backdated to represent conversions in the prior year, even though filing deadlines take place in April.
As I mentioned above, the five-year rule dictates that distributions, over and above the amount contributed and/or the amount converted, that are taken prior to the five year wait period after the establishment/conversion of the account are not tax-free. See the examples below for a comparison of scenarios.
John, at 57 years of age, makes a maximum contribution of $6000 to his Roth IRA on April 15, 2007 for the tax year of 2006. On January 1st, 2011, John decided to withdraw $8000 from his Roth IRA. Of the $8,000 that John withdraws, $6,000 is principal contribution, and $2,000 is profitable earnings.
Results: Since John is now over the age of 59.5 and his five-year rule has expired (Jan 1, 2006 – Jan 1, 2011), the entire distribution is qualified for a tax-free distribution and isn’t included as taxable income. In the example above, John made a profit of $2,000 over a period of almost four years but because his first contribution in the Roth IRA was dated back to January 1, 2006, his wait for tax-free distributions was considerably shorter than five years.
**Note that he was over the required age of 59.5 for tax-free distributions as well.
Now let’s look at the same example if John takes his distribution after only three years of participating in a Roth IRA:
John, at 57 years of age, makes a maximum contribution of $6000 to his Roth IRA on April 15, 2007, for the tax year of 2006. On January 1st, 2009, John decided to withdraw $8000 from his Roth IRA. Of the $8,000 that John withdraws, $6,000 is principal contribution, and $2,000 is earnings. Even though John is now over the age of 59.5, his distribution on the earnings is being taken out of the account before the five-year rule expires. $2,000 of his distribution must be claimed as taxable income on his tax return.
Results: After age 59 1/2 and once the five-tax-year holding period is met, any distribution from the Roth IRA will be considered a qualified distribution and be tax-free. Remember that each conversion from a pre-tax IRA will start its own individual five-year waiting period. You may consider keeping any conversions and/or contribution accounts separated in different Roth IRAs for organization purposes.