5 year wait for tax free ROTH
It is my understanding that although ROTH IRAs are touted as generating an account that is tax free upon redemption, that tax free description holds only after the investment has been in the ROTH account for five years. If that is correct, then consider the following:
On Dec 31, 2011, Joe has $110,000 in a traditional IRA; he has already withdrawn his 2011 RMD. On Jan 2, 2012 he decides to convert it all to a ROTH. But first, he must withdraw his $10,000 2012 RMD. Having done so, the remaining $100,000 is converted to a ROTH. Over the next five years his account appreciates at 5% yearly, leading in Jan of 2017 to a balance of $127,628. Joe then – perhaps foolishly – decides to withdraw it all, tax free, since five years have passed. But only the original $100,000 has been in for 5yrs. CAN he withdraw it all, or must each successive increment of appreciation await it’s own 5yr maturing?
Thanks.
DBRJ
Permalink Submitted by Peter Lingane on Thu, 2011-12-29 16:07
The (somewhat simplified) ordering rules that apply to distributions from a Roth IRA are that the originally contribution or conversion amounts are distributed first followed by earnings. Multiple Roth IRAs are treated as a single account for purposes of the ordering rules.
Thus Joe could withdraw up to $100,000 at any time from the Roth IRA without income tax or penalties. (Penalties can be complicated but not in this case since Joe is taking RMDs.)
Earnings are tax free once five years have elapsed since the original contribution/conversion to any Roth IRA, assuming the participant is aged 59.5 (or has died, become disabled, et cetera) at the time of withdrawal.
Thus Joe could withdraw the entire account in January 2017 without tax or penalties.
If Joe had established a Roth IRA in, say, 2005, he could withdraw the entire account the day after the conversion without tax on penalties.
The rules are a bit different for designated Roth 401(k) or 403(b) accounts.
Choate discusses these rules with examples in her excellent book “Life and Death Planning for Retirement Benefits” available from ataxplan.com for about $100.
Permalink Submitted by david johnston on Thu, 2011-12-29 16:38
Peter
A clear answer.
You bring up an interesting point: the five year clock starts running with Joe’s first ROTH. So, if I understand it correctly, having actually opened his first ROTH in Jan 2010, ALL Joe’s earnings from his 2012 ROTH conversion will only have to wait ’till Jan 2015 to be tax free upon withdrawal.
DBRJ
Permalink Submitted by Alan Spross on Thu, 2011-12-29 18:18
Yes, 1/1/2015 the entire Roth balance will be qualified and tax free.
However, if the first Roth contribution done in Jan, 2010 was for the year 2009, then the Roth would be fully qualified 1/1/2014. The 5 year clock begins with the year of the first Roth contribution that is a valid contribution. For example, if there were no earnings on which to base a contribution for the first year, any contribution would be excess and would not start the 5 year clock.
Permalink Submitted by david johnston on Thu, 2011-12-29 21:01
Hello again, Alan
I had forgotten about the “contribution/ April 15”- business with IRAs; no, Joe’s Jan 2010 opening deposit was for calendar/tax year 2010.
Although I don’t see how it would impact things in this case, I am baffled by your phrase “no earnings on which to base a contribution for the first year”. Are you suggesting that if Joe’s 2010 investment didn’t earn anything, that would be equivalent to “no earnings on which to base a contribution for the first year”? But with the initial 2010 opening of the account, isn’t the clock already ticking? So where would this “excess contribution” come from and when WOULD the clock start ticking?
Sorry to be so slow.
DBRJ
Permalink Submitted by Alan Spross on Thu, 2011-12-29 21:49
By “no earnings on which to base the contribution”, I was referring to earned income on which the contribution must be based. Some people make Roth contributions when their income is too high to qualify but if an excess contribution is made the clock cannot start running based on that contribution.
In other words, the 2010 contribution must be valid in order to start the clock in 2010.
Permalink Submitted by david johnston on Thu, 2011-12-29 22:39
Yet another level of complications I hadn’t considered. Joe retired prior to 2010, and has had no “earned” income since. The 2010 opening of his first ROTH came from conversion of a traditional IRA. That should be valid and the clock should now be running.
Permalink Submitted by Alan Spross on Thu, 2011-12-29 23:36
Yes, as long as the conversion is not fully recharacterized, it will start the clock in the year the conversion was deposited in the Roth. And starting in 2010 everyone is eligible to convert so there is no possibility of a failed conversion.