Roth Conversion 5-year Withdrawal Question
Hello, we have a client who has begun doing $10,000 Roth conversions annually, which he plans to continue. These are conversions and not annual contributions. How does the 5-year withdrawal rule apply? Our client asks when can he withdraw rollover amounts, after 5 years from beginning or after 5 years from the last conversion or maybe his rollover contribution a year at a time, 5+ years later? Maybe only age 59½. Thanks very much. Paul McGillivray
Permalink Submitted by Alan - IRA critic on Fri, 2020-12-11 22:13
The 5 year holding period to avoid the penalty applies separately to each conversion, but they all stop upon reaching 59.5 if they have not otherwise been completed. If a conversion occurs at 56.5, then that holding period will effectively be only 3 years until age 59.5. Conversions come out only after all regular contributions, and then by order of the oldest conversions first. Therefore, if client is no where near 59.5, and does a conversion each year, after 5 years the first conversion is available without penalty, and the following year the second conversion etc. Of course, if he needed to withdraw a conversion before the 5 years, he could but would owe the 10% penalty unless he qualified for another penalty exception.
Permalink Submitted by John Boyle on Sun, 2020-12-20 20:54
To be clear, the growth portion of a backdoor Roth at age 57 will also be tax-free at age 59.5 as long as the Roth met the five year holding period? There is no reason to segregate that contribution?
Permalink Submitted by David Mertz on Sun, 2020-12-20 22:38
Correct. Once the individual has reached age 59½ and it has been at least 5 years since the beginning of the year for which the individual first made a Roth IRA contribution (including conversions), any distribution from any of the individual’s Roth IRAs is tax and penalty free no matter how the money came to be in the individual’s Roth IRAs.
Permalink Submitted by John Boyle on Fri, 2021-03-19 21:33
The IRS publication is so unclear (surprise). Publication 590 says “a separate 5-year period applies to each conversion..”. Nowhere can I find something that says “only if you’re younger than 59 1/2”. I’ve read numerous times on this forum where it is said (to paraphrase): once 5 years and 59 1/2 is reached, and a conversion occurs, the conversion and future gains of the conversion are immediately tax-free. Is there a place in publication 590 that details this?
Permalink Submitted by Alan - IRA critic on Fri, 2021-03-19 22:46
There are two entirely different Roth 5 year holding periods, the first which deals when distributions are tax free and the other that deals only when conversions can be distributed without the 10% penalty. So the first deals with ordinary income tax and the second (conversions) deals with the 10% penalty, which is an “early distribution penalty”.
The first income tax related 5 year holding period is paired up with reaching 59.5. When you first opened your Roth more than 5 year ago AND you reach 59.5, your Roth is fully qualified and tax free.
The second 5 year holding requirement for conversions is for the 10% penalty only when you withdraw from a conversion done less than 5 years ago. This penalty only applies to early withdrawals of conversions, and once you reach 59.5, the withdrawal is not “early”, so this penalty does not apply. Therefore, the conversion 5 year holding requirement lasts 5 years, but never beyond 59.5.
I agree that Pub 590B is difficult to follow, particularly for the conversion holding period, which is referred to as a “recapture tax”. It is called that because Congress arbitrarily decided that since the 10% penalty for distributions from an IRA before 59.5 does not apply to conversions, they did not want people converting to avoid the penalty and then withdrawing their conversions shortly thereafter, escaping the penalty. They selected 5 years as the arbitrary length of time that was long enough that someone is unlikely to use this tactic to avoid the penalty. But because distributions from a TIRA are only subject to penalty prior to 59.5 (an early distribution), there was no need to recapture the penalty on a Roth distribution after 59.5. In short, this penalty (recapture tax) applies to the taxable portion of conversions for the shorter of 5 years or until reaching 59.5.
This is also partially explained in the Form 5329 Inst. 5329 is the form on which this penalty is reported if you are subject to it.