Roth 5 Year Conversion Rules – What You Need to Know

Roth IRAs are good retirement savings options. Although you can’t deduct contributions to a Roth IRA, the money inside the account grows tax-free. Payouts of earnings after age 59½ are generally not taxable.You can also withdraw your contributions at any time on a tax-free basis and without having to pay a penalty. Payouts of earnings before 59½ are hit with a 10% fine.   But be sure you know the two five-year rules. The first applies to Roth IRA contributions…And whether distributed earnings are tax-free to you. Payouts of earnings after 59½ aren’t taxed if at least five tax years have passed since the owner first contributed to a Roth IRA. The five-year clock starts the first time money is deposited into any Roth IRA that you own, through either a contribution or a conversion from a traditional IRA.The clock doesn’t restart for later Roth payins or for newly opened Roth IRA accounts. Here are two examples that illustrate the effect of this first five-year rule. Scenario 1: You are 61 and you funded your first Roth IRA three years ago. In 2024, you take a distribution. You will be taxed on the earnings in the account because it’s been less than five years since you first contributed to the Roth IRA. Scenario 2: You’ve owned a Roth IRA since 2014. In 2022, you opened and funded a second Roth IRA. Because you funded your first Roth in 2014, you needn’t wait five years to take money from your second Roth for the earnings to be tax-free, provided you are at least 59½ at the time of the distribution. The second five-year rule applies specifically to Roth IRA conversions…And whether the 10% early distribution penalty hits pre-age-59½ payouts. The next five-year rule doesn’t apply to new contributions to Roth IRAs, but to conversions of pretax income from traditional IRAs to Roths. Under the rule, if someone under 59½ does a Roth conversion, and later takes a payout within five years of the conversion and before turning 59½, then the amount of conversion principal that is withdrawn is hit with the 10% penalty. Once you turn 59½, you needn’t worry, even if you take a payout before your conversion meets the five-year period. For example, there’s no 10% penalty if you do a conversion at age 58 and withdraw funds at age 60.   Under this rule, each conversion has its own separate five-year period, which differs significantly from the first five-year rule discussed above. For instance,if you do multiple Roth IRA conversions, there will be multiple five-year time periods,even if each conversion is done into the same Roth IRA account you owned for years.   Second five-year rule example. You are 51 and convert your traditional IRA into a Roth that you have had for many years. You will be taxed on the converted amount. Four years later, you liquidate the Roth. Your post-conversion earnings will be subject to ordinary income tax rates and the 10% penalty because you are not age 59½ at the time of the distribution. Additionally, your converted principal will also be hit with the 10% penalty.  If you are over 59 ½, then only the earnings would be subject to ordinary tax if withdrawn before the 5 year anniversary.