Roth IRA Contributions & Conversions – Understanding The 5-Year Rules (Part 2)
In Part 1 of this series, we examined the 5-year holding period rule governing the taxation of earnings distributed from a Roth IRA. We learned that if this rule is followed, earnings on Roth contributions may be withdrawn income tax and penalty free. In this post, we’ll look at the second 5-year holding period rule, which applies to Roth conversions from traditional IRAs and other qualified retirement accounts.
The Roth conversion 5-year holding period rule is used to determine whether funds converted to a Roth IRA from a traditional IRA or other qualified plan account may be withdrawn without a 10% tax penalty. Income tax is not an issue here as income taxes are paid at the time of the conversion. To meet this 5-year holding period rule, the converted funds may not be withdrawn from the Roth IRA until 5 tax years have passed from the year of conversion.
The rule’s primary objective is to prevent investors from avoiding the 10% penalty on pre age 59½ withdrawals from a traditional IRA or other retirement account by simply converting the funds to a Roth IRA, paying the income tax due, and thereafter withdrawing the converted funds.
Like the 5-year rule for earnings, the conversion 5-year holding period is based upon the year, not the day of the conversion. Any conversion is deemed made as of January 1 of the tax year in which the conversion occurs, and ends on December 31 of the fourth consecutive year after the year of the conversion.
For instance, Jack, age 48, funded a Roth IRA in 2021 with money converted from his traditional IRA. The 5 years that apply to his 2021 conversion are 2021, 2022, 2023, 2024, and 2025. Thus, Jack may withdraw the converted funds without penalty at any time after December 31, 2025.
Unlike the holding period rule applicable to Roth contributions, each conversion has its own 5-year holding period. Thus, if an account owner makes multiple conversions to a Roth IRA there may be several different holding periods that the owner must track.
Withdrawals of conversion funds are deemed to occur on a first-in, first-out basis. Where an account owner makes multiple Roth conversions, the funds from the oldest conversion are deemed withdrawn first, and the most recent funds converted are deemed withdrawn last.
Note well — Conversion funds may be distributed penalty free before the end of the applicable 5-year holding period if one of the statutory exceptions to the penalty apply to the distribution. These exceptions include; i)withdrawals occurring after the account owner attains the age of 59½; ii) withdrawals due to the account owner’s death; and iii) withdrawals due to the disability of the account owner.
Let’s take a look at a few examples to see how this rule works in practice:
In 2021, Susan, age 42, converted funds from her traditional IRA to her Roth IRA. The conversion funds may be withdrawn penalty free on or after January 1, 2026. The 5 tax years that must pass to satisfy the holding period are 2021, 2022, 2023, 2024, and 2025. After December 31, 2025, Susan may withdraw the converted funds penalty free, even though she may be only 47 years old at that time.
Same as example 1, except Susan withdraws the converted funds in 2025. She will be assessed the 10% penalty on the withdrawal because she did not wait the full 5 tax years.
John, age 58, opened a Roth IRA in 2019 and funded the account that same year with money converted from his traditional IRA. In 2022, John, then age 61, withdrew the converted funds from his Roth IRA. The withdrawal is not subject to the 10% penalty even though it occurred before the end of the 5 year holding period because he met the “at least age 59½” exception to the penalty.
The Roth IRA holding period rules can be very tricky in application. In the next installment we’ll take a look at some of the finer points pertaining to these rules.
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