Does a Five-Year Holding Period Apply to Each Roth Conversion?

By Sarah Brenner and Jeffrey Levine
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This week’s Slott Report Mailbag, coming to you live from our 2-Day IRA Workshop in Philadelphia, contains questions from consumers screaming (sometimes literally) for help! In several cases, the issues involve the magic age of 59 ½ and cover a variety of topics, including life insurance issues, 72(t) payments with a divorce and the Roth IRA 5-year rules. As always, we recommend that you work with a competent, educated financial advisor to keep your retirement nest egg safe and secure. You can find one in your area here.
 

1.

Help!

I am receiving my deceased husband’s life insurance policy. This matter is highly sensitive to me. The policy was purchased in 1972 for $50,000. It is now worth $220,000. In 2009, it was worth $154,000. They are mailing the check today. I am 70 and want it for my son only. I live on Social Security only. What are my tax obligations? It appears the amount is all interest! I contacted you because of seeing Ed Slott on public television.

Answer:
We would need to know more details about your specific situation before giving you a definite answer. It sounds like you may be receiving life insurance proceeds, but you said “contract,” which could mean you’re talking about something else altogether, like an annuity. Different types of investments are taxed differently, so it would probably be best to consult with a knowledgeable professional who can review the specific details of your situation.
 

2.

I have read some of your input on splitting a 72(t) when a divorce is impending. My husband wants to split the distributions until he reaches age 59 ½. Is this a wise choice or is there a chance that if he gets remarried, the 401(k) could be left to his new wife (i.e. change her to the beneficiary)? Is it possible I could be in for a legal battle in 3 years when he reaches age 59 ½ for my half of the 401(k)? The 401(k) is in his name only, but we’ve been married 28 years with one child.

Thanks in advance,

Susan

Answer:
You may be entitled to a part of your husband’s 401(k) plan if you divorce. Company plans, including 401(k) plans, are often divided in a divorce by a court order know as a Qualified Domestic Relations Order (QDRO). If you would receive a distribution from the plan pursuant to a QDRO, the distribution would be taxable but not subject to the 10% early distribution penalty. You may be able to roll over the distribution to an IRA.

If your husband is currently set up to take substantially equal periodic payments or 72(t) distributions from his 401(k), he should consult with a knowledgeable professional about the effect a divorce would have on these payments and whether they should continue to avoid penalties. Generally, the payment plan may not be modified until an individual reaches age 59 ½ or until five years have passed since the payments began – whichever is longer.
 

3.

I have been given conflicting answers to this question.

I am older than age 59 ½ and have held a Roth IRA for more than 5 years, so I know I wouldn’t owe tax or penalty on any distributions including earnings from this account.

I would like to start converting portions of my Traditional IRA over the next several years to a Roth IRA and was told by my mutual fund company that any distributed earnings would not be subject to a five-year holding period because: 1) I am older than age 59 ½ and 2) I have held ANY Roth (i.e., the contributory Roth) for more than 5 years.

However, I have also read and been told by various sources that regardless of age, a five-year holding period applies to each conversion and that the earnings portion of any distribution from a converted IRA would be subject to tax and penalty if withdrawn prior to 5 years of each conversion. I would like to have the option to “cash out” of a converted Roth should the need arise but not at the expense of penalties and taxes on the earnings. Can you please clarify this for me? I know I am not the only one confused about this rule.

Answer:
The rules for taking qualified or tax-free distributions from Roth IRAs can be complicated. There are two separate five-year holding periods, but in your situation, neither five-year period will be a problem. All of your distributions from any of your Roth IRAs will be tax and penalty free forever because you are over age 59 ½ and you have held a Roth IRA for more than five years. You can’t mess that up, even if you try!
 

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