last in first out with Roth annuity during first 5 years?
I have a client with a traditional IRA who wants to transfer those funds into a preexising Roth that is over 5 years old. Once he transfers the TRIA to the Roth, he then wants to take the funds to pay the taxes out of the Roth. From there, he wants to establish a Roth annuity and transfer some of the funds to the Roth annuity from the 5 plus year old Roth and in essence, split the Roth in two. [u]Will the new Roth annuity have a new 5 year waiting period that must pass before he can enjoy tax free income from the new Roth annuity or will it be exempt from a new 5 year holding period by virtue of the fact that funds passed through the Roth that had already been established longer than 5 years? [/u]
Furthermore, if the new Roth annuity does in fact need to pass a new 5 year period before tax free funds can be removed from it, and the client draws the interest off of the annuity starting immediately, will the interest drawn be taxed or would it be considered return of a part of the original cost basis of the Roth and be tax free?
thanks
Permalink Submitted by Alan Spross on Thu, 2009-03-05 23:19
The 5 year holding period used to determine when a Roth IRA is qualified is based on the year of the first Roth contribution. But the Roth owner must also be over 59.5 for the Roth to become qualified for earnings to be tax free. The new Roth annuity uses the original date of the first Roth for this holding period.
Conversions have a separate 5 year holding requirement to avoid the early withdrawal penalty on conversion dollars as well. This requirement ends when the owner reaches 59.5.
Withdrawals from the Roth before the account is qualified follow the ordering rules. First out is regular contributions, then conversions, and finally earnings.
There is not enough data to reply to the specific questions:
1) Client’s age?
2) If not over 59.5, is there enough in regular contributions to pay the income tax coming out of the Roth?
3) If conversion dollars are needed for the taxes as well, client must be 59.5 to avoid 10% early withdrawal
4) The Roth annuity can be part of a custodial Roth whereby the payout is held in the Roth and NOT distributed to the client. This is an option to consider.
5) If client is 59.5 when distributions occur, they are fully tax free because all his Roths are then fully qualified. If not the ordering rules above apply. If conversion dollars come out the 10% tax applies until 59.5 and if earnings come out both income tax and the 10% tax apply to the earnings.
Permalink Submitted by WILLIAM Czerkies on Thu, 2009-03-05 23:31
Thank you for the reply. The client is 71 years old and I understand you reply relating to his age. However, I am not familiar with your reply in #4, but here is a little more detail. The TIRA has approximately 500k in it. The client is in a 10% tax bracket and is strongly entertaining making the conversion all in one year with the understanding that he will be paying the highest possible tax, but he thinks it might just be better to get it over with and enjoy the tax free income from then on. His motivation to pay it all in one year is that he understands that stringing out the conversion over a period of years will have a net result of increasing the tax on his social security. I am not sure if any of this relates to your answer in #4. If the payout is held in a custodial roth, the client would not be able to spend those dollars. The ultimate goal is to give him as much tax free income as possible while paying the lowest amount of taxes on the conversion while considering the effective tax paid on social security during the conversion years if not converted all in one year. Thanks
Permalink Submitted by Alan Spross on Thu, 2009-03-05 23:37
Since he is over 59.5, all Roth distributions are fully tax free, so there are no issues with the Roth distributions.
However, SS payments are not high enough to offset having 500,000 taxable in a single year. He will have much of this in the top bracket. Of course, if he converts in 2010 the income will be split between 2011 and 2012 for tax purposes. Probably should have a tax pro project the total tax bill for up front vrs 2010 vrs incremental conversions.