5-year Rule for Roth Conversion
Just a quick point of clarification as there seems to be some confusion about this. Let’s say an individual age 70 converts a $100,000 IRA to a Roth. A year later the account has grown to $110,000. He then wants to redeem the entire account. The question is, is there any penalty or tax on the $10,000 gain?
Thanks.
Permalink Submitted by Alan Spross on Thu, 2011-06-16 20:26
There is no penalty, but the 10,000 in gains will be taxable if the taxpayer had not made their first Roth contribution (either regular or conversion) at least 5 years earlier. There are two requirements for earnings to be tax free, first the 5 year holding period and second being at least 59.5.
Also, if the taxpayer would have reached 70.5 during the year of the conversion, the RMD would have to be taken out prior to the conversion and the RMD amount itself cannot be converted.
Permalink Submitted by Sidney Poretsky on Thu, 2011-06-16 21:54
Thanks for clarifying that point. Yes, the RMD was taken prior to the conversion. One thing further: Let’s say the individual dies shortly after the conversion, and the widow now makes it her Roth IRA. If she then wants to cash it in, is the now spousal Roth Conversion IRA still subject to the same 5-year holding period for the gain not to be subject to income tax?
Permalink Submitted by Alan Spross on Thu, 2011-06-16 22:07
When the surviving spouse assumes ownership of the inherited IRA, they are treated as if they were the original owner of it. Therefore, the 5 year clock started in the same year as the original owner or in the year the surviving spouse opened their own Roth IRA, whichever is earlier.
Therefore, if the surviving spouse never had their own Roth previously, the 5 year period runs continuously over both their lifetimes, and if earnings were cashed in prior to completion they would be taxable and could also be subject to penalty if the surviving spouse was not yet 59.5. If the surviving spouse was not yet 59.5 and wanted to cash in the entire Roth, that should be done while it was still in inherited form to eliminate the early withdrawal penalty.
Permalink Submitted by Sidney Poretsky on Sat, 2011-06-18 14:03
One final thing: Would the 5-year rule still apply even if the IRA owner and his wife were in their 80’s when he converted his IRA to a Roth? I seem to recall hearing that after age 70-1/2 there were no 5-year rules.
Permalink Submitted by Alan Spross on Sat, 2011-06-18 18:47
Yes, the IRA must still exist for 5 years for earnings to be tax free, regardless of age when the first Roth contribution is made. This holding period carries over to beneficiaries.
But there is another 5 year holding period, and that one applies to conversions that can be withdrawn without a penalty. That holding period disappears at age 59.5 along with other early distribution penalties. You may have been thinking about this one based on the title of your post. This one also disappears for any inherited IRA regardless of age since a death distribution never has an early withdrawal penalty.