Roth IRA Distributions
This is probably a pretty basic question, but I need a definitive answer since I have clients this will affect immediately. I have been advising clients to convert to Roth IRA’s like most of you have. My question is, If the client is over age 59 1/2 when the conversion takes place and wants to make a withdrawal before the 5 year period is satisified, is there a penalty? The client will only withdrawal the contributions, not the earnings. My research shows that it will not be a “Qualified Distribution”, but it looks as if the distribution of the contributions would be allowed without penalty, within the 5 year holding period. Am I right or not?
Donald
Permalink Submitted by Alan Spross on Tue, 2010-02-09 19:26
Donald,
Yes, you are correct. There are no early withdrawal penalties after age 59.5 and that includes the Roth conversion 5 year holding period.
However, the 2010 conversion rules create another issue if clients plan to defer taxes for two years, but take out any of the converted amounts prior to 2012. This will accelerate the tax they could have deferred into the year the conversion dollars are taken out. This is not an extra tax, just loss of tax deferral from the special two year deferral on 2010 conversions only.
Example: Convert 100k, plan to report 50 in 2011 and 50 in 2012. However, takes out 30k in 2010. This will result in the conversion income being reported @ 30k in 2010, 50k in 2011 and 20k in 2012.
Permalink Submitted by Henry Godbee III on Wed, 2010-03-03 19:13
Continuing the senario with the TIRA holder being over 59.5: Would it be correct to say that following the conversion, all contributions and ernings can be withdrawn without penalty or taxes, assuming the full converted amount is claimed on the 2010 tax return (which is filed in 2011)? In other words, the 5 year holding period does not apply to either the converted amount or to the subsequent earnings for a person over 59.5. Your comments please.
Permalink Submitted by Alan Spross on Wed, 2010-03-03 19:52
Remember that there are two totally different holding periods for Roth IRAs, one for earnings being qualified and the other to avoid early withdrawal of conversions.
Being over 59.5, there is no longer a 5 year holding period for conversions, however, any earnings distributed before the Roth is qualified will be taxable. The Roth is not qualified until BOTH age 59.5 and the 5 year holding period from the year of the first Roth contribution of any type is met.
Permalink Submitted by Henry Godbee III on Thu, 2010-03-04 15:04
[b]One More Time:[/b]Since you used the words conversion [u]and[/u] contribution in your explanation, I want to use the following example for further clarification. Mr. Smith opens and funds (contributes to) a Roth IRA when he is 55. He makes no further contributions. At 61 he retires with a large 401k. He rolls over his 401k to an traditional IRA (trustee to trustee tranfer).
He is now 62 and converts his tranditional IRA to a Roth IRA. Miraculously his account doubles. Since he is over 59.5 and he has had a Roth IRA for over 5 years, he is free to withdraw all contributions and earnings income tax free?
Switching to a practical question: Are custodians able to segregate the earnings from the conversion amount so that a withdrawal of converted contributions is tax free?
Permalink Submitted by Alan Spross on Thu, 2010-03-04 19:07
Correct. The 62 year old can withdraw any or all amounts from the Roth IRA tax and penalty free because the Roth is fully qualified.
On the custodian question, the answer is “no”. Taxation of Roth distributions includes treating all Roth accounts owned as one combined account. And a given custodian would have no idea of either the existence or constitution of any other Roth IRA accounts the owner may have. Therefore, about all they know for sure is the Roth owner’s age and whether THEIR OWN account has met the 5 year holding period. If so, the custodian knows that any other Roth accounts would also be fully qualified. They would then code their 1099R with a “Q” for qualified which means that no 8606 is needed to report the distribution. It goes only on line 15a of the Form 1040.
Custodians of other Roth IRA accounts held less than 5 years will not know whether the ROth is qualified or not because it depends on other accounts. But they do know the age, and therefore should code the 1099R with a “T”. At that point the 8606 instructions leave reporting up to the taxpayer. If the taxpayer’s Roth accounts are in fact qualified due to at least one of them meeting the 5 year requirement, they are similarly advised to simply enter the distribution on line 15a. The 8606 is needed for Roth distributions only prior to qualification of the owner’s Roth accounts.
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With respect to Roth contributions, there are two types, regular contributions and conversion contributions. Either type starts the 5 year clock for qualification of all Roth IRAs. Each conversion contribution also has it’s own 5 year clock for early withdrawal penalties. All early withdrawal penalties end at age 59.5 or when another penalty exception is met, eg disability or death.
Permalink Submitted by Henry Godbee III on Thu, 2010-03-04 20:01
Your answers are great! Thanks. However, I have just one more (For your sake, I hope only one). Let’s assume there is only one (1) Roth conversion account. The accont owner is over 62 but the conversion was made only 3 years ago. How does the account owner withdraw only the converted amount out of the Roth conversion account without withdrawing the interest? How is the custodian going to deal with this? Is it assumed that all withdrawals are cost basis (no tax) until the withdrawals exceed the conversion amount?
Permalink Submitted by Alan Spross on Thu, 2010-03-04 20:31
In this case, the Roth is NOT yet qualified because the 5 year holding period has not been met. For non qualified Roth distributions, automatic ordering rules apply as outlined on p 66 of Pub 590. FIrst out are any regular contributions, then conversions, and any earnings are last. It is up to the IRA owner to keep track of these amounts if they want to know the tax implications of their distribution. The custodian is not going to keep track.
In the example, the Roth owner would keep a record showing the amount of the conversion, and there are no regular contributions in this example. The owner could withdraw up to the amount of the original conversion tax free because tax has already been paid, and penalty free because he is over 59.5. The custodian does not keep track of this, and will distribute the amount requested, so the Roth owner must keep track of it.
If more than the conversion is distributed, those amounts must be earnings and would be taxable. Form 8606 would report the distribution and any resulting taxable amount would be transferred to line 15b of Form 1040. There would be no early withdrawal penalty on the taxable amount due to being over 59.5.
If this conversion was made in 2007, the Roth will be qualified as of 1/1/2012. Ordering rules cease to apply in 2012 because there is no longer any reason to keep track of various amounts of contributions and conversions, less distributions. What all this means is that Roth distribution reporting is complex if distributions are taken before the Roth is qualified, but very easy starting in the year of qualification.
Permalink Submitted by Henry Godbee III on Fri, 2010-03-05 19:28
Thanks for your thorough and clear explanation. It is always appreciated.