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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 for penalty-free distributions of converted funds. 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59 ½, any withdrawal before that time would be subject to the 10% penalty the account owner would have paid if she had withdrawn from her traditional IRA.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.

I am an Ed Slott Master Elite trained IRA Specialist and I would like to help you. If you have any questions regarding this article or would like to schedule a complimentary consultation, please call my office at 845-627-8300. My Client Service Coordinator will be happy to set up a convenient time so I can help. 

Warm Regards,

Beth Blecker CEO Eastern Planning Inc. 

Follow Beth Blecker on Twitter: @EasternPlanning

“Ed Slott’s Elite IRA Advisor Group” is solely an indication that the financial advisor has attended training provided by Ed Slott and Company. Ed Slott is not affiliated with Royal Alliance Associates, Inc. Securities and advisory services offered through Royal Alliance Associates, Inc. Member FINRA/SIPC. Securities and advisory services offered through Royal Alliance Associates, Inc. (RAA), member FINRA/SIPC. RAA is separately owned and other entities and/or marketing names, products or services referenced here are independent of RAA. Copyright © 2022, Ed Slott and Company. Reprinted with permission Ed Slott and Company, LLC takes no responsibility for the current accuracy of this information.

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