Need help understanding the 5 Year Holding Period?
When it comes to converting to a Roth IRA, for the most part I get it. The one hiccup that I just can’t seem to wrap my head around is the five-year holding period. Can you please help me understand by using a few different scenarios. Say, a 57-year-old individual has $100,000 they want to convert into a Roth from an old 401(k). In the first example, let’s say that the individual had opened a Roth IRA back in 2005. How does the five-year holding period work in this person’s situation if the individual wants to take a distribution at 59-1/2.
Scenario two: Just to keep it simple, let’s keep the numbers and the age the same, the only difference is this individual does not own a Roth IRA. What happens if they convert at 57 and want to take a distribution at 59-1/2. I am sure I can muddy the waters and ask a bunch of other questions, but I think if I can get this, it will all make sense to me.
Permalink Submitted by Alan Spross on Fri, 2012-03-30 18:48
First scenario – individual has already met the 5 year holding period and at 59.5 his entire Roth IRA is fully qualified. That means the entire balance could be distributed without tax or penalty, and is referred to as a qualified distribution.
Scenario 2: This Roth will not be qualified until age 62 since the 5 year holding period will not be met until then. But at 59.5, taxpayer can take out everything but the earnings tax and penalty free, and that would likely be most of the balance. At 62, Roth will be fully qualified and the earnings would be tax free then as well.
Note that there are two different 5 year holding periods:
1) For earnings to be tax free – this is the holding period discussed above and measured from 1/1 of the year of first Roth contribution of any type (regular or conversion).
2) For conversions to be distributed without the 10% penalty. To illustrate this holding period, in your second example, assume the conversion was distributed prior to 59.5. Even though taxes had been paid on the conversion, there would still be a 10% penalty since the conversion had not been held 5 years and 59.5 had not been reached. This 5 year holding period ends at 59.5 if taxpayer reaches 59.5 before the 5 years is achieved.
Hope this helps.