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TWO 5-year Rules for Roth IRAs

In case the rules surrounding Roth IRAs weren’t confusing enough so far, there are actually TWO 5-year rules that can apply to your Roth IRA account.

5-Year Rule #1: The Account’s Age

first ride on the bus 5-year ruleThe first 5-year period begins on January 1 of the tax year when you established and first funded the account. This 5-year rule is important in determining if any distributions you receive from the account are qualified. In order to be qualified, a withdrawal must occur at least 5 years after the account establishment date (January 1 of the year you first funded the account). In addition to the 5-year rule, one of the following conditions must also apply in order for your distribution to be considered qualified:

See the IRS’ flowchart in Figure 2-1 (page 30) at this link in order to determine if your distribution is qualified.

5-Year Rule #2: Age of a Conversion

The second 5-year rule applies to a 5-year period beginning on January 1 of the year of a conversion to a Roth IRA from a traditional IRA or from a qualified retirement plan such as a 401k. If any amount that was subject to taxation during the conversion is distributed before the 5-year period is complete will be subject to an additional 10% penalty applied to the distribution. This would also include post-conversion earnings on all amounts converted within the prior 5 years.

There are several exceptions to this rule, listed here:

  • You have reached age 59½
  • You are disabled
  • You are the beneficiary of a deceased IRA owner
  • You use the distribution to pay certain qualified first-time homebuyer amounts
  • The distributions are part of a series of substantially equal payments (SOSEPP)
  • You have significant unreimbursed medical expenses
  • You are paying medical insurance premiums after losing your job
  • The distributions are not more than your qualified higher education expenses
  • The distribution is due to an IRS levy of the qualified plan
  • The distribution is a qualified reservist distribution
  • The distribution is a qualified disaster recovery assistance distribution
  • The distribution is a qualified recovery assistance distribution

Why These Rules Are Important: Distribution Ordering Rules

The two 5-year rules come into play when considering the order in which distributions are attributed. The IRS has specific rules determining which money is coming out of your account based on the source. The distribution ordering rules determine how each distribution is to be treated, depending on if it’s qualified or not. The order of distribution is as follows:

  1. Regular contributions (this is your annual contribution amount to the account, not rollovers or conversions)
  2. Conversion and rollover contributions, on a first-in, first-out basis. This means that the total of conversions and rollovers from the earliest year are distributed first. These conversions and rollovers are further sorted as follows:
    1. Taxable portion (that portion that was taxed during the conversion or rollover) is distributed first, followed by the
    2. Non-taxable portion (any amounts that were not taxed during the conversion)
  3. Earnings on all contributions

It should be noted that, in determining the amounts for #2 (conversion and rollover contributions) that certain aggregation rules apply:

  • Add all distributions from all your Roth IRAs during the year together.
  • Add all regular contributions made for the year (including contributions made after the close of the year, but before the due date of your return) together. Add this total to the total undistributed regular contributions made in prior years.
  • Add all conversion and rollover contributions made during the year together. For purposes of the ordering rules, in the case of any conversion or rollover in which the conversion or rollover distribution is made in 2018 and the conversion or rollover contribution is made in 2019, treat the conversion or rollover contribution as contributed before any other conversion or rollover contributions made in 2019.

Of course, the regular contributions can always be taken out of the account tax free (no 5-year rule applies). After that, the two 5-year rules kick in on the rest of the types of funds in your account.

5 Comments

  1. Jane J says:

    Contributions to a Roth IRA can be withdrawn at any time without penalty – with no 5 year restriction. No?

    1. jblankenship says:

      Yes, that’s correct (that’s the last paragraph of the article).

      1. Bill DeRosa says:

        What is not stated is what I call the “Roth Trap”.
        In 2011 I converted about $1M to a Roth which has grown to about $2M. In 2016 I did another conversion of about $25K in a separate account that is only worth about $26K now. I am now building a house and have distributed the $1.025 in conversion amounts. I need to distribute some of the earnings and find that since the earnings from all accounts are aggregated that I will face a tax bill on distribution unless I wait until 2021.

        Am I missing something? I created the separate account for the second conversion that the accounts would be treated spsrately. When I go through the worksheet in publication 590 this does not appear to be true.

        I have seen several writings on this topic but the writers don’t appear to have dug deep enough on this.

        1. jblankenship says:

          Unfortunately, I think you’re right about this. Once you get to the earnings, unless you meet one of the exceptions (over age 59 1/2, etc.) you are subject to tax and penalty on distributions.

          1. Bill DeRosa says:

            Jim,
            It’s worse than that! I am over 59 1/2. The real bad news is that I would have to pay tax on the distribution.

            I, actually, simplified my situation in my previous comment. I followed a strategy of Roth Conversions for years that it made sense based on my tax bracket and Medicare IIRMA status for that year. This was based on my interpretation and advice from writers at Kiplinger and the former WSJ Smart Money publications. The popular misconception seems to be that each conversion is treated separately.

            I kept each distribution in separate accounts and felt comfortable I could tap them at will after the 5 years expired. Unfortunately, the aggregation of all of the accounts in the IRS regulations subjects the earnings to taxation based on the most recent conversion. I suspect the legislation that created Roths did not intend this but since the IRS did not call this out as an exception to regular IRA rules it sets a trap.

            My situation, which has $1M in earnings held hostage to a $26K, distribution, is probably extreme. I suspect others will, unwittingly, fall into this trap using conversion strategy tauted by many advisors. I have done pretty extensive research on this being in my current situation. It seems inconceivable that this trap exists, but, when you get to the very complex distribution rule in publication 590 it appears.

            I suggest that since you have the platform that you should verify what I have found and inform your readers. You would be a pioneer in turning around the misinformation that is out there that sets this trap.

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