Give Me Five

Rick Moberg

ARE YOU PLANNING to withdraw funds from your Roth IRA? If you aren’t careful, you could owe both taxes and penalties, even though you’ve already paid taxes on the money that went into the Roth. At issue: the IRS’s five-year rule. How do you sidestep its unpleasant consequences? Bear with me while I explain.

First, a word of caution: You don’t have to take distributions from your Roth IRA during your lifetime. Withdrawals are strictly up to you. Indeed, it’s a good idea to keep assets in your Roth for as long as possible, so you enjoy a long period of tax-free growth. The five-year rule encourages you to do just that.

The rule states that, to avoid income taxes and penalties, you must keep certain assets in your Roth IRA for at least five years. The five-year period is based on calendar years. The clock starts on Jan. 1 regardless of whether you funded your Roth on Jan. 1 or Dec. 31 of that year. For example, if you made a contribution or a conversion on Dec. 31, you only need to wait just over four years.

Your Roth IRA might contain regular annual contributions and conversions from a traditional IRA, as well as the subsequent investment gains earned on these dollars. Think of these as three distinct buckets of money. The five-year rule states that these three buckets come out of your account in a particular sequence—one that actually benefits you.

Regular annual contributions are deemed to come out of the account first. There are no income taxes owed when you pull out your original Roth contributions, because you’ve already paid income taxes on this money. There are also no penalties. The upshot: Contributions may be withdrawn at any time by anyone, including those under age 59½, at no tax cost.

Converted amounts, if any, are deemed to be distributed next. Again, there are no income taxes on converted amounts, because you’ve already paid taxes on these dollars. Conversions may be withdrawn at any time by anyone with no income tax cost, including by folks under 59½. A 10% early withdrawal penalty, however, may apply if you’re under 59½.

The purpose of the 10% penalty is to prevent the under-59½ crowd from using Roth conversions to circumvent the 10% early withdrawal penalty that applies to traditional IRAs. The worry: Folks would convert a traditional IRA to a Roth, simply so they could immediately pull the money out penalty-free.

Still, even if you’re under 59½, there are three ways to avoid the 10% penalty. First, you could leave converted amounts in your Roth for at least five years. Second, money can be withdrawn penalty-free if the distribution is due to your death or disability. Finally, you can avoid the penalty if you use the distribution for what the IRS calls a “qualified purpose.” Those exceptions include a qualified first-time home purchase, qualified medical expenses, health insurance premiums while unemployed and qualified higher education expenses.

That brings us to the third bucket: the account’s investment gains. These earnings are deemed to be distributed last and potentially face the most onerous tax consequences, including both income taxes and a 10% early withdrawal penalty. How do you avoid that one-two punch? The rules are complicated, but much hinges on your age.

To avoid both income taxes and tax penalties on your Roth’s investment gains, you can’t withdraw these earnings until you meet the five-year requirement—and you typically have to be over age 59½.

What if you are indeed over 59½? You won’t be charged the 10% tax penalty. But you could still get hit with income taxes if it’s been less than five years. In most cases, however, that won’t be a problem—because, before you start withdrawing your Roth’s investment earnings, you’ll be pulling out the other two buckets of money: your original contributions and any conversion amounts.

Rick Moberg is the retired chief financial officer of a publicly traded software company. He has an MBA in finance, is a CPA and has a passion for personal finance. Rick lives outside of Boston with his wife. His previous article was To Roth or Not.

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