Understanding the (2) Five Year Rules for Roth IRAs

bee

A well written explanation of a confusing topic:

The bottom line, though, is simply this: it’s important to remember that there are two separate 5-year rules, each with their own requirements and stipulations. The Roth conversion 5-year rule is about accessing penalty-free conversion principal (and is irrelevant if the individual already meets one of the other exceptions to the early withdrawal penalty), while the Roth contribution 5-year rule is about accessing tax-free Roth earnings (which are assumed to be extracted last, anyway).

https://kitces.com/blog/understanding-the-two-5-year-rules-for-roth-ira-contributions-and-conversions/

Sven

Thank you. The examples help to clarify the fine points and various scenarios many investors face.

hank

@bee says, “a confusing topic ...”

That’s the reason I’ve always elected to sit tight for 5 years following a conversion. Over-kill I know. And it’s nice to realize you don’t have to wait to pull the principal out. Where it could become muddling (maybe a new adjective?) is when you move that money into another Roth somewhere else that was converted earlier and is no longer subject to the earnings hold - and than you start moving it in and out of various other funds! Is the new custodian clear re the money’s status? Is the IRS clear? Are you 100% clear?

Finally transferred out some of the 2015 conversion at Oppenheimer. By sticking with those guys the full 5 years, was able to turn what looked like a sure-fire trip to the “woodshed” after the first 2 or 3 years into a handsome gain after 5. So, one never knows how things will pan out ...


Thanks @bee for posting this.

catch22

Hi @hank
Having contributed to a Roth IRA in prior years, I'm aware of the form 5498 provided by the company where one holds the Roth.
I've not performed a Roth conversion and am curious as to whether your also received the same form, indicating the money placed into the Roth.

This is a cite from TurboTax regarding form 5498 and other related info. The first several paragraphs are more to this point.
Thank you.
Catch

msf

To @hank's concern about comingling multiple conversions: Kitces points out that for tax purposes all the accounts are combined into one virtual account anyway.

That's similar to the way RMDs are handled, which is more familiar. You've got multiple T-IRAs, each with its own RMD. You can take the total out of one account and the IRS will treat it as though you'd taken the proper amount out of each IRA account.

For convenience purposes, because the Roth rules aggregate together all Roth accounts under IRC Section 408A(d)(4)(A), there is no need to keep Roth contributions and conversions in separate accounts, or to otherwise try to separate out multiple types of contributions. The aforementioned ordering rules (principal first, then conversions on a FIFO basis, then earnings) apply in the aggregate across all accounts.

In other words, the money that you took out of that Oppenheimer 2015 conversion Roth was viewed by the IRS as if you'd taken the money out of your older Roth. That's because the ordering rules for withdrawals say that money is attributed to older conversions first.

The custodian cannot know when the clock for "first Roth contribution" started, because you could have Roth IRAs with other institutions. But the IRS does know about all contributions and conversions because the custodians are required to file 5498s reporting this information.

Since all Roths are aggregated for tax purposes, the IRS doesn't need to know anything about which account holds which conversions.

hank

Hi @Catch22 - I can’t answer that very well. Process for all 4 conversions between 2009 and 2016 appeared to work the same way. Perhaps it helps to understand that in each case, I converted 100% of whatever was held in a Traditional IRA at the particular fund house: D&C & Oakmark (both in 2009), Oppenheimer (2015) and Permanent Portfolio Funds (2016). So all I had to do was phone each of those and ask them to mail me the necessary paperwork.* I’ll assume it was the document you’re asking about or that they transposed whatever I mailed back to them onto the correct IRS document. I made copies of the paperwork at the time, of course. But if you could view my haphazardly stored collection of old documents, you’d understand why I’m not about to go digging.

*Correction: In the case of the first two conversions (2009), I did not wait for documents to be mailed out. Instead, I phoned each custodian who explained the necessary instructions for completing the form(s) and than downloaded whatever they told me to online to speed up the process. You may recall the S&P’s direction resembled a WW II “Jap Kamikaze“ in early March ‘09.

It was up to me to estimate / mail taxes to the IRS. Other than mailing in taxes, I had no direct contact with them. Law requires larger sum taxes (here, essentially Traditional IRA withdrawals) be paid earlier than the next year’s April 15 filing date. There’s actually IRS coupons you can download for mailing each systematic payment (in increments) over the year. Recall mailing several installments in throughout the year. (All the conversions were early in the year.) Also have some vague recollection that there was a temporary more generous IRS provision for conversions in effect in 2009. I believe one had something like 3 years to pay up - but might be wrong on that point.

Hope this helps answer your question Catch, I do think conversions are a good idea - but more so if you can time them so you’re converting assets at temporarily depressed prices.

hank

“In other words, the money that you took out of that Oppenheimer 2015 conversion Roth was viewed by the IRS as if you'd taken the money out of your older Roth.”

Thanks @msf. I’d actually seen that point explained somewhere back than - but than later came across contradictory information. As @bee said, there’s a lot of confusion out there. All in all, timing the withdrawals / transfers made little difference to me - especially after the first couple met the 5-year threshold. In the current case, the funds are going from Invesco’s ultra-short bond fund into TRP’s slightly better ultra-short.* But I understand the points you are making here might be immensely beneficial to others contemplating such a move.

*By doing some swapping-out between Trad and Roth holdings at TRP, the cash position will end up in the Trad. account rather than in the Roth. That’s a plus.

msf

@Catch22 - the answer is in the Intuit page you cited: "Although a rollover or conversion of assets from one retirement plan into an IRA isn’t deductible, they are considered contributions and will be reported in boxes 2 and 3 of Form 5498."

The IRS instructions for Form 5498 say the same thing: The trustee "must report the receipt of a conversion from an IRA to a Roth IRA even if the conversion is with the same trustee. Report the total amount converted from a traditional IRA, SEP IRA, or SIMPLE IRA to a Roth IRA in box 3."

Since most Roths don't have RMDs, and you also get a 1099R for the amount withdrawn from the T-IRA, you can usually disregard the 5498. It is primarily an info document for the IRS.

If the Roth does have an RMD, then you should use the year end balance shown on the 5498 to calculate the amount of that RMD.

Sven

Kitces also pointed out that ...

once the 5-year rule has been satisfied once for a taxpayer (i.e., if you’ve already had a Roth for at least 5 tax years), it’s been satisfied for good; in turn, this means that recent contributions may actually be eligible for withdrawal as a qualified distribution even if they’ve been in the account for less than 5 years, as long as the taxpayer overall has met the 5-year requirement with respect to any Roth IRA.

Assuming the investor also meet the first requirement of over 59 1/2 and the second requirement of holding an existing Roth for at least 5 years, he/she qualifies the tax-free distribution under IRC Section 408A(d)(2)(A).

Examples he cited in the above article help to clarify the matter. I still have much to learn in order to understand the details on RMD of traditional IRAs. Fortunately Vanguard has several great articles.