Retirement Account Rollovers: Today’s Slott Report Mailbag

By Ian Berger, JD
IRA Analyst
Follow Us on Twitter: @theslottreport

Question:

I read your November 29, 2017 explanation of rollovers and the time limitations. But my issue is still unclear to me.

In December 2018, my husband made a transfer from his 401(k) to an IRA to a Roth IRA. We intended to do the same this year, but an unexpected bill hit us, and we took a distribution from the 401K two weeks ago. Taxes were taken out. The bill turned out to be much less than expected and so, we would like to roll over the distribution into his existing Roth account. Since the December one was a transfer and this one would be a 60 day rollover, is it permitted? And if so, can we do another transfer in a few months?

Thank you in advance. 

Nina

Answer:

Hi Nina,

You are wise to be concerned about the timing of your transactions, but you should be OK. 

The IRS has a “once-per-year rule” that limits anyone from making more than one IRA rollover in any 12-month period. (The 12-month period is not a calendar year.) Violating this rule could cause serious tax consequences.

Fortunately, the once-per-year rule applies only to 60-day rollovers – not direct transfers (when funds are transferred directly to the IRA custodian). And, only certain 60-day rollovers are covered: those from one regular IRA to another regular IRA and those from one Roth IRA to another Roth IRA. Rollovers between a company plan and an IRA are exempt from the rule.

So, if your December 2018 transaction was a direct transfer, the 12-month clock didn’t start ticking with that transaction. And, since your upcoming 60-day rollover will be from a 401(k) to an IRA, it won’t start ticking with that transaction, either. The same is true with any future direct transfers you do.

Question:

Thank you for the opportunity to submit questions concerning our traditional IRA’s.

When we retired my wife and I had a traditional IRA and a 401(k) at our employer. A couple of years after we retired, we rolled our respective 401(k)’s over into our respective traditional IRA’s.  Now we are considering rolling over annual amounts into newly created Roth IRAs for each of us at our brokerage house where our traditional IRA’s are administered.

We are somewhat confused concerning the 5 year holding period before funds can be withdrawn without penalty from the Roth Rollover. We have been told that the five year period applies to each annual rollover to our Roth and others have told us that there is only one five year holding period which applies only to the first rollover and not subsequent rollovers. Which is true?  Furthermore, as we are both over 59 ½ years old, must we wait the 5 year period before being able to withdraw Roth IRA funds without penalty.

Thank you for considering our questions.

Chandler and Cheryl

Answer:

Hi Chandler and Cheryl,

There’s lots of confusion about the 5-year Roth IRA rules, so we’re not surprised you’re getting different answers. 

What’s really confusing is that there are actually two 5-year rules. The good news is that you only have to worry about one.

The one you don’t have to worry about (Rule #1) determines whether amounts converted to Roth IRAs can be hit with the 10% early distribution penalty. The one you may have to worry about (Rule #2) determines whether earnings in a Roth IRA can be hit with taxes and the 10% penalty.

You can withdraw amounts you convert from your traditional IRA to a Roth IRA at any time without paying income tax. You’re stuck with the 10% early distribution penalty only if the withdrawal occurs before the end of a 5-year holding period (Rule #1) AND before age 59 ½.

Not that it matters to you, but the Rule #1 holding period applies separately to each Roth conversion and begins on the first day of the year of each conversion.

Since you’re both over 59 ½, you don’t have to worry about violating the Rule #1 holding period, and you can take your converted amounts at any time free from tax or penalty.

Earnings that you withdraw are handled differently. You are subject to both income tax and the 10% penalty if the withdrawal occurs before the end of a 5-year holding period (Rule #2) OR before age 59 ½. (There are special rules if a withdrawal of earnings is made on account of death, disability or first-time home purchase.)

The Rule #2 holding period starts when you do your first Roth IRA conversion. Unlike the Rule #1 holding period, it doesn’t re-start with each conversion. And, the 5-year period begins on January 1 of the year of your first conversion – no matter when the conversion actually occurs.

IRS rules allow you to withdraw all of your converted amounts (first in, first out) before touching your earnings. Since you’re over age 59 ½, any earnings you withdraw won’t be subject to tax or penalty — as long as you wait until the end of the 5-year period that starts on January 1 of the year of your first Roth IRA conversion.