Watch Out for the Five-Year Rule on Converted Roth Funds
If you are under age 59 ½ and you converted your traditional IRA to a Roth IRA, you will need to watch out for the five-year rule regarding distributions.
Make sure that you have an understanding of these rules as you plan for your financial situation.
Not understanding how the rule works can result in unexpected penalties when you withdraw your Roth IRA funds.
If you make annual tax year contributions to your Roth IRA, you can always access those funds tax- and penalty-free. That is pretty easy to understand. However, when it comes to converted funds, it gets a little more complicated. You can always access your converted funds tax-free – even if you are under age 59 ½. That makes sense because you already paid the tax bill when you did the conversion.
It’s a different story when it comes to the 10% early distribution penalty. If you are under age 59 ½, you must satisfy a five-year holding period on funds that were taxable when converted before you can access those funds penalty-free.
The five-year holding period will restart for each conversion and is effective as of January 1 of the year of conversion. If the conversion was done any time in 2022, the holding period for this five-year rule begins on January 1, 2022.
The best way to understand this five-year rule for penalty-free distributions of converted funds is to know exactly what it is set up to prevent. When you take a distribution from your traditional IRA and convert it to a Roth IRA, that distribution is taxable but not subject to the 10% early distribution penalty. This fact meant that soon after Roth IRAs became law, those looking for tax loopholes started advising under 59 ½ IRA owners that they could get out of the 10% penalty by doing a conversion. IRA owners could just convert their IRA to a Roth IRA and then, the next day, withdraw funds from the Roth IRA tax- and penalty-free.
Congress quickly shut this loophole and now we have the “conversion five-year rule”: If the converted funds are not held for at least five years or until age 59 ½, any withdrawal before that time would be subject to the 10% penalty the account owner would have paid if she had withdrawn from her traditional IRA.
Don’t confuse this “conversion five-year rule” with the other five-year rule (the “forever five-year rule”). that also applies to Roth IRAs. The forever five-year rule determines whether distributions of earnings from Roth IRAs are tax-free. That rule works differently from the conversion rule. The forever rule for tax-free distributions always applies no matter what your age is. Also, it begins with your first contribution or conversion to any Roth IRA, and it never restarts even if future contributions or conversions are made.
By Sarah Brenner, JD
Director of Retirement Education
Ed Slott and Company, LLC