Roth Conversion – 5 year window
I have a higher net worth client that is interested in funding a Roth but can’t based on income. The idea is to contribute to a Traditional IRA and convert it to a Roth. From my understanding Tax implications are minimal because how much can it really be in a week. My question is the following: Does each conversion year after year have it’s own 5 year window for Roth Qualification or is it just from the date of the first conversion?
Thank you – C. Sanders
Permalink Submitted by Alan Spross on Tue, 2012-07-31 16:48
Typically, the individual does not qualify for a TIRA deduction and therefore makes a non deductible contribution and reports it on Form 8606. It can then be converted tax free except for any earnings IF there is no other TIRA, SEP or SIMPLE IRA pre tax balance. This practice is sometimes referred to as a “back door Roth contribution”.
If the conversion is tax free, the 5 year holding period is moot because the penalty only applies to the taxable part of the conversion and these conversions are mostly tax free. If 5,000 is contributed and it grows to 5,040 before the conversion, then the penalty for withdrawing that conversion is 10% of the pre tax amount of $40, a $4 penalty. Since the penalty is so small, the taxpayer can distribute the 5,040 conversion without waiting 5 years at a minimal cost. If this situation is repeated in later years, each year’s conversions are subject to their own 5 year waiting period to completely avoid any penalty in the event a part of the conversion was taxable.
If such a conversion is totally tax free, it receives the same tax treatment as a regular Roth contribution, ie it can be withdrawn tax and penalty free at anytime.
Permalink Submitted by Curtis Sanders on Tue, 2012-07-31 18:54
Thank you for clarification. Very Helpful.