Turning Back the Clocks and Revisiting the Roth IRA Five-Year Clocks

By Ian Berger, JD
IRA Analyst
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A few weeks ago, many of us were required to turn back our clocks one hour and say goodbye to daylight savings time. And with that change came the usual reminder to change the batteries in our smoke detectors. Based on the number of questions we continue to get about the Roth IRA five-year distribution rules, we think that adjusting the clocks should come with another reminder – on how the Roth IRA clocks work.

The confusion about the Roth IRA distribution rules isn’t really surprising since there’s actually two clocks, each used for different purposes and each with different rules.

The First Clock: Is a Distribution of Converted Amounts Subject to Penalty?

The first five-year clock is used for only one purpose: to determine whether a distribution of converted Roth amounts is subject to the 10% early distribution penalty. The good news is that this is not an issue when the person receiving the distribution is age 59 ½ or older since the penalty doesn’t apply. And, even if the person is under 59 ½, the penalty also doesn’t apply if the converted amount has been held for at least five years. This five-year clock actually starts ticking on January 1 of the year of the conversion, so the holding period can be less than five years. To complicate things even further, if someone does more than one conversion, each conversion has its own five-year clock. But if the Roth funds remain untouched until retirement (i.e., beyond age 59 ½) as they should, the first five-year clock won’t ever come into play.

The Second Clock: Is a Distribution of Earnings Subject to Taxes?

The second clock has nothing to do with the 10% early distribution penalty. Instead, it helps determine whether earnings on Roth IRA contributions and conversions are taxable when distributed. This second clock (called the “forever clock” by my colleague Andy Ives) starts ticking on January 1 of the year the person makes her first contribution or conversion to ANY Roth IRA – not necessarily the one where the distribution is coming from. So, there is no separate clock for each contribution or conversion. Getting the forever clock ticking is why it’s so important for everyone to open up a Roth IRA as early as possible – even if funded with a nominal amount. In order for earnings to be tax-free, it’s not enough for this second clock to be satisfied. The person receiving the distribution also must be at least 59 ½ (or disabled or a first-time home buyer). When both conditions are satisfied, earnings come out tax-free in a “qualified distribution.”

But it’s not a tragedy if a Roth distribution is not “qualified.” That’s because the Roth IRA ordering rules say that contributions and conversions are deemed to come out before earnings. This means that someone can always receive a tax-free distribution of an amount equal to their Roth contributions and conversions without even reaching their earnings (in other words, before the second clock even comes into play).